AVANEX CORP - 10-Q Quarterly Report

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15 (d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. YES x NO ¨

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). YES x NO ¨

There were 144,763,288 shares of the Company’s Common Stock, par value $.001 per share, outstanding on May 2, 2005.

We design, manufacture and market fiber optic-based products, known as photonic processors, which are designed to increase the performance of optical networks. We sell our products to telecommunications system integrators and their network carrier customers. We were founded in October 1997, and began making volume shipments of our products during the quarter ended September 30, 1999.

The accompanying unaudited condensed consolidated financial statements as of March 31, 2005, and for the three and nine months ended March 31, 2005 and 2004 have been prepared in accordance with U.S. generally accepted accounting principles (“GAAP”) for interim financial statements and pursuant to the rules and regulations of the Securities and Exchange Commission, and include the accounts of Avanex Corporation and its wholly-owned subsidiaries (collectively “Avanex” or the “Company”). Certain information and footnote disclosures normally included in annual financial statements prepared in accordance with GAAP have been condensed or omitted pursuant to such rules and regulations. In the opinion of management, the unaudited condensed consolidated financial statements reflect all adjustments (consisting only of normal recurring adjustments) necessary for a fair presentation of the consolidated financial position at March 31, 2005, the consolidated operating results for the three and nine months ended March 31, 2005 and 2004, and the consolidated cash flows for the nine months ended March 31, 2005 and 2004. The consolidated results of operations for the three and nine months ended March 31, 2005 are not necessarily indicative of results that may be expected for any other interim period or for the full fiscal year ending June 30, 2005.

The condensed consolidated balance sheet at June 30, 2004 has been derived from the audited consolidated financial statements at that date, but does not include all of the information and footnotes required by GAAP for complete financial statements. These unaudited condensed consolidated financial statements should be read in conjunction with the Company’s audited consolidated financial statements and notes for the year ended June 30, 2004 contained in its Annual Report on Form 10-K filed with the Securities and Exchange Commission on September 13, 2004.

During the nine months ended March 31, 2005 and 2004, the Company incurred net losses of $65.6 million and $102.4 million, respectively, and its balance of cash, cash equivalents and unrestricted short and long-term investments declined from $122.4 million at June 30, 2004 to $54.5 million at March 31, 2005. These factors cast substantial uncertainty on the Company’s ability to continue as an ongoing enterprise for a reasonable period of time. The Company’s ability to continue as an ongoing enterprise in its current configuration is dependent on its securing additional funding. The financial statements do not include any adjustments relating to the recoverability and classification of recorded asset amounts or the amounts and classification of liabilities that might be necessary should the Company be unable to continue as an ongoing enterprise.

Certain reclassifications have been made to the condensed consolidated balance sheet as of June 30, 2004 to conform to the current period presentation. The condensed statement of operations for the three and nine months ended March 31, 2005 and the condensed statement of cash flows for the nine months ended March 31, 2004 have been reclassified to conform to the current period presentation. Such reclassifications did not affect previously reported results of operations or retained earnings.

The operating results of the Company’s silica planar lightwave circuit (PLC) product line manufactured in Livingston, Scotland, which was sold in February 2004, are reflected as discontinued operations in the accompanying consolidated statement of operations for the three and nine months ended March 31, 2004.

On July 31, 2003, the Company acquired Alcatel Optronics France SA, a subsidiary of Alcatel that operated the optical components business of Alcatel, to augment its optical technologies and intelligent photonic solutions product line with dense wave division multiplexing (DWDM) lasers, photodetectors, optical amplifiers, high-speed interface modules and key passive devices such as arrayed waveguide multiplexers and Fiber Bragg Grating (FBG) filters. Alcatel also assigned and licensed certain intellectual property rights to the Company. In addition, the Company acquired certain assets of the optical components business of Corning to augment its optical technologies and intelligent photonic solutions product line with optical amplifiers and lithium-niobate modulators. Corning also assigned and licensed certain intellectual property rights to the Company. In consideration for the above, the Company issued shares of its common stock to Alcatel and to Corning, representing 28% (35.4 million shares) and 17% (21.5 million shares) at the date of acquisition, respectively, of the outstanding shares of the Company’s common stock on a post-transaction basis. The transactions were accounted for under the purchase method of accounting.

On August 28, 2003, the Company acquired certain assets of Vitesse Semiconductor Corporation’s Optical Systems Division to enhance its presence in transponders and expand its product offerings in subsystem products. The Company acquired substantially all of the assets of Vitesse’s Optical Systems Division in exchange for 1.4 million shares of Avanex common stock. The transaction was accounted for under the purchase method of accounting.

The common stock issued in the acquisitions was valued based on the average closing price for two trading days prior to the day of, and two trading days subsequent to the public announcement of the transactions.

Under the purchase method of accounting, the total purchase price as shown in the table above was allocated to the net tangible and intangible assets based on their estimated fair values as of the date of the completion of the transaction.

The Company allocated the purchase price of acquired companies and assets to the tangible and intangible assets acquired and liabilities assumed based on their estimated fair values. The Company engaged an independent third-party appraisal firm to assist it in determining the fair values of the assets acquired and the liabilities assumed. Such valuations required management to make significant estimations and assumptions, especially with respect to intangible assets.

The Company acquired developed technology from Alcatel, which is comprised of products that are technologically feasible, primarily including DWDM lasers, photodetectors, optical amplifiers, high-speed interface modules and passive optical devices. Core technology and patents represent a combination of Alcatel’s Optronics division processes, patents and trade secrets. The Company amortizes the developed technology on a straight-line basis over an estimated life of 3-4 years. The Company acquired developed technology from Corning, which is comprised of products that are technologically feasible, primarily including optical amplifiers, dispersion compensation modules and modulators. Core technology and patents represent a combination of the optical components business of Corning processes, patents and trade secrets. The Company amortizes the developed technology on a straight-line basis over an estimated life of 3-4 years. The Company acquired developed technology from Vitesse, which is comprised of products that are technologically feasible, primarily including transponders. Core technology and patents represent a combination of the optical components business of Vitesse processes, patents and trade secrets. The Company amortizes the developed technology on a straight-line basis over an estimated life of 3-4 years.

Critical estimates in valuing certain intangible assets include, but are not limited to: future expected cash flows from customer contracts, customer lists, supply agreements, and acquired developed technologies and patents. Management’s estimates of fair value are based upon assumptions believed to be reasonable, but which are inherently uncertain and unpredictable.

The purchase price for the Corning Assets and Vitesse Assets resulted in the recognition of goodwill. The primary factor contributing to the recognition of goodwill for Vitesse Assets was the ability to integrate a workforce with technical expertise. The primary factors contributing to the recognition of goodwill for the Corning Assets included the integration of a workforce with technical expertise and a deeper penetration of the Company’s current customer base with a broader portfolio of products. The Company expects that the goodwill for both the Corning and the Vitesse acquisitions will be deductible for tax purposes in the United States.

The following unaudited pro forma information presents a summary of our consolidated results of operations as if the Alcatel, Corning and Vitesse acquisitions had taken place at July 1, 2003 (in thousands, except per share amounts):

3. Pro Forma Disclosure of the Effect of Stock-Based Compensation (in thousands, except per share amounts)

The Company accounts for its stock-based compensation plans under the recognition and measurement principles of Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees,” and related interpretations. The following table illustrates the effect on net loss and net loss per share if the Company had applied the fair value recognition provisions of Statement of Financial Accounting Standards Board (FASB) No. 123, “Accounting for Stock-Based Compensation” to stock-based employee compensation (in thousands, except per share amounts).

On December 16, 2004 the Financial Accounting Standards Board issued FASB Statement No. 123R: “Share-Based Payment” (“SFAS 123R”), which is a revision of FASB Statement No. 123, Accounting for Stock-Based Compensation. SFAS 123R supersedes APB Opinion No. 25, Accounting for Stock Issued to Employees, and amends FASB Statement No. 95, Statement of Cash Flows. Under SFAS 123R, all shared-based payments to employees, including grants of employee stock options, are to be expensed in the financial statements based on their fair value determined by applying a fair value measurement method. Regardless of which transition method a company selects, the cumulative effect of adopting SFAS 123R would be recognized on July 1, 2005. The Company will be required to implement SFAS 123R on July 1, 2005. The Company is currently evaluating the impact of the change in accounting in light of SFAS 123R. The Company believes that the impact will be significant to net loss but the Company will not know the full impact on the financial statements until it is implemented.

Inventories consist of raw materials, work-in-process and finished goods and are stated at the lower of cost or market. Cost is computed on a currently adjusted standard basis (which approximates actual costs on a first-in, first-out basis). Inventories consisted of the following (in thousands):

In the first nine months of fiscal 2005 and 2004, the Company recorded charges to cost of revenue for the write-down of excess and obsolete inventory of $4.8 million and $0.9 million, respectively. In the first nine months of fiscal 2005, the write-down was primarily due to excess inventory from discontinued products. Management did not believe it could sell or use this inventory in the future. Actual results may differ from such forecasts.

The total cost of inventory written-off from inception to March 31, 2005 is approximately $53.1 million. Of this amount, items representing $12.1 million have been sold, items representing $1.8 million have been consumed in research and development activities, items representing $25.8 million have been discarded, and items representing $13.4 million are on hand. The ultimate disposition of the inventory items on hand will occur as the Company continues its integration and consolidation of its acquisitions and continues its transition of manufacturing to third-party manufacturers in Asia.

The following table reflects other intangible assets subject to amortization as of the date indicated (in thousands):

The estimated future amortization expense as of March 31, 2005 is as follows (in thousands):

Goodwill represents amounts arising from acquisitions that closed in fiscal 2004 and amounted to $9.4 million at March 31, 2005 and June 30, 2004.

In general, the Company provides a product warranty for one year from the date of shipment. The Company accrues for the estimated costs of product warranties during the period in which revenue is recognized. The Company estimates the costs of its warranty obligations based on its historical experience and expectation of future conditions. To the extent the Company experiences increased warranty claim activity or increased costs associated with servicing those claims, the Company’s warranty costs will increase resulting in decreases to gross profit. The Company periodically assesses the adequacy of its recorded warranty liabilities and adjusts the amounts as necessary.

Changes in the Company’s product warranty accrual are as follows (in thousands):

The Company maintains a revolving line of credit with a financial institution, which allows maximum borrowings up to $10.0 million and terminates on January 1, 2006. This line of credit requires the Company to comply with specified covenants. At March 31, 2005 and June 30, 2004 the Company had borrowings of $3.9 million and $3.7 million, respectively, against this line. Additionally, the line of credit secures two letters of credit totaling approximately $2.7 million in the aggregate relating to certain facility leases, which expire in September 2005 through April 2006. The line bears interest at prime plus 1.25% and, at March 31, 2005 the effective interest rate was 7.0% and at June 30, 2004, the effective interest rate was 5.25%. The line of credit is collateralized by $5.6 million in short-term investments and $6.8 million in long-term investments at March 31, 2005 and a pledge of all the Company’s assets.

In January 2004, the Company entered into an installment payment agreement with a financial institution whereby the financial institution agreed to loan to the Company an aggregate principal amount of $865,000 to finance the acquisition of SAP software, which is collateral for the outstanding loan under the agreement. The designated interest rate for the loan is 5.2% and the maturity date for the loan is November 28, 2006. The outstanding balance on the loan was $521,000 and $730,000 as of March 31, 2005 and June 30, 2004, respectively.

In February 2001, the Company entered into a loan agreement with a financial institution to borrow $2,269,000 to be used to finance equipment, which is collateral for the outstanding loan under the agreement. The loan, which bore interest at 9.406% was fully repaid as of March 31, 2005, and had an outstanding balance of $126,000 as of June 30, 2004.

The Company leases certain of its equipment and other fixed assets under capital lease agreements. The assets and liabilities under capital leases are recorded at the lesser of the present value of aggregate future minimum lease payments, including estimated bargain purchase options, or the fair value of the assets under lease. Assets under capital leases are amortized over the shorter of the lease term or useful life of the assets. The capital lease obligations amounted to $9.1 million as of March 31, 2005 and $9.9 million at June 30, 2004 at interest rates ranging from 3.1% to 11.48% with varying maturity dates through fiscal 2009. These obligations include the capital lease obligation of $2.3 million, which the Company entered into in March 2005 for certain equipment.

A summary of the Company’s restructuring accrual is as follows (in thousands):

In fiscal year 2004, the Company acquired the optical components businesses of Alcatel and Corning. As part of the acquisitions, the Company recorded acquisition-related liabilities at July 31, 2003 with a fair value of $64.1 million relating to future workforce reductions, which were included in the purchase price of the optical components businesses of Alcatel and Corning. A summary of the acquisition-related liability relating to these acquisitions is as follows (in thousands):

We expect to pay $6.3 million of the balance of the workforce reduction accrual within the next twelve months.

Over the past several years, the Company has implemented various restructuring programs to realign resources in response to the changes in the industry and customer demand, and the Company continues to assess its current and future operating requirements accordingly.

During the nine months ended March 31, 2005, the Company implemented several workforce reduction plans primarily related to a reduction in force of approximately 132 employees, and accrued $8.5 million in restructuring charges. This amount was offset by recoveries of $461,000 from previous workforce restructuring plans in our European operations after it was determined that certain estimated payments were no longer required.

During fiscal year 2003, the Company announced the closing of its facility in Richardson, Texas and the integration of the functions in Richardson into its facility in Fremont, California. During fiscal 2003 and 2004, the Company continued to downsize its workforce, primarily in its manufacturing operations and further consolidated its facilities in Fremont.

In connection with restructuring certain leased facilities in fiscal 2004, the Company issued warrants to purchase 60,000 shares of its common stock to a landlord amounting to $407,000 (valued using the Black-Scholes method). These warrants have an exercise price of $7.39 per share and expire on November 30, 2010.

The following table summarizes changes in the restructuring accrual for the nine months ended March 31, 2005, excluding accruals related to the acquisitions noted above (in thousands):

We expect to pay the balance of the workforce reduction accrual within the next twelve months. Amounts related to the abandonment of excess leased facilities will be paid as the payments are due through the remainder of the lease terms through 2010. Capital lease payments were due over the term of the leases and were completed in the quarter ended March 31, 2005.

The following table presents the calculation of basic and diluted net loss per share (in thousands, except per share data):

During all periods presented, the Company had options and warrants to purchase common stock outstanding, which could potentially dilute basic earnings per share in the future, but were excluded from the computation of diluted net loss per share, as their effect would have been antidilutive. Options to purchase 19,309,137 shares of common stock were outstanding at March 31, 2005 and options to purchase 15,900,079 shares of common stock were outstanding at March 31, 2004. Warrants to purchase 60,000 shares of common stock were outstanding at March 31, 2005 and March 31, 2004.

On July 31, 2003, Alcatel was issued 28% of the Company’s common stock and Corning was issued 17% of the Company’s common stock on a post-transaction basis. Alcatel and Corning own shares of Avanex common stock representing 19.55% and 11.87%, respectively, of the outstanding shares of Avanex common stock as of May 2, 2005. The Company sells products to and purchases raw materials and components from Alcatel and Corning in the regular course of

business. Additionally, Alcatel and Corning provided certain administrative and other transitional services to the Company. Amounts paid to related parties were as follows (in thousands):

Receivables due from related parties originating at the date of acquisition are amounts owed by Alcatel contractually payable to the Company subsequent to the original transaction. Additionally, amounts are due from Corning related to warranty repairs of optical products sold by Corning prior to the acquisition.

SFAS No. 131, “Disclosures about Segments of an Enterprise and Related Information,” establishes standards for the way public business enterprises report information about operating segments in annual financial statements and requires that those enterprises report selected information about operating segments in interim financial reports. SFAS No. 131 also establishes standards for related disclosures about products and services, geographic areas and major customers.

The Company operates in one business segment, which focuses on the development and commercialization of fiber optic-based products. The Company has adopted a matrix management organizational structure whereby management of worldwide activities is on a functional basis.

For the three months ended March 31, 2005, sales to Alcatel, Ciena, and Cisco Systems accounted for 32%, 13% and 10%, respectively of net revenues, compared with sales to Alcatel, Cisco Systems and Nortel, which accounted for 30%, 22%, and 15%, of net revenues for the same period in the prior fiscal year. For the nine months ended March 31, 2005, sales to Alcatel accounted for 36% of net revenues, compared with sales to Alcatel and Cisco Systems, which accounted for 29% and 22%, of net revenues for the same period in the prior fiscal year. The preceding customer sales figures include sales to their contract manufacturers.

Foreign currency translation adjustments for the three months ended March 31, 2005 and 2004 were a loss of approximately $102,000 and a loss of $1.8 million respectively, resulting in a comprehensive net loss of $19.0 million and $42.8 million, respectively. Foreign currency translation adjustments for the nine months ended March 31, 2005 and 2004 were a gain of approximately $546,000 and a gain of $4.4 million, respectively, resulting in a comprehensive net loss of $65.0 million and $98.0 million, respectively.

On August 6, 2001, Avanex, certain of its officers and directors, and various underwriters in its initial public offering (“IPO”) were named as defendants in a class action filed in the United States District Court for the Southern District of New York, captioned Beveridge v. Avanex Corporation et al., Civil Action No. 01-CV-7256. This action and other subsequently filed substantially similar class actions have been consolidated into In re Avanex Corp. Initial Public Offering Securities Litigation, Civil Action No. 01 Civ. 6890. The consolidated amended complaint in the action generally alleges that various investment bank underwriters engaged in improper and undisclosed activities related to the allocation of shares in Avanex’s IPO. Plaintiffs have brought claims for violation of several provisions of the federal securities laws against those underwriters, and also against Avanex and certain of its directors and officers, seeking unspecified damages on behalf of a purported class of purchasers of Avanex’s common stock between February 3, 2000, and December 6, 2000. Various plaintiffs have filed similar actions asserting virtually identical allegations against more than 40 investment banks and 250 other companies. All of these “IPO allocation” securities class actions currently pending in the Southern District of New York have been assigned to Judge Shira A. Scheindlin for coordinated pretrial proceedings as In re Initial Public Offering Securities Litigation, 21 MC 92. On October 9, 2002, the claims against Avanex’s directors and officers were dismissed without prejudice pursuant to a tolling agreement. The issuer defendants filed a coordinated motion to dismiss all common pleading issues, which the court granted in part and denied in part in an order dated February 19, 2003. The court’s order did not dismiss the Section 10(b) or Section 11 claims against Avanex. In June 2004, a stipulation of settlement for the claims against the issuer defendants, including Avanex, was submitted to the court. The settlement is subject to a number of conditions, including approval of the court. If the settlement does not occur, and litigation against Avanex continues, Avanex

believes it has meritorious defenses and intends to defend the action vigorously. Nevertheless, an unfavorable result in litigation may result in substantial costs and may divert management’s attention and resources, which could seriously harm our business, financial condition, results of operations or cash flows.

Certain former employees of Avanex France SA (formerly Alcatel Optronics) in Lannion, France who were terminated following Avanex’s acquisition of the optical components business of Alcatel sued Avanex France SA for damages relating to an alleged breach of promise to pay them a “welcome bonus” that was paid to other employees who were not terminated. Avanex’s total expected liability from this lawsuit is approximately $1.3 million and Avanex has recorded the liability in its financial statements. Avanex intends to defend the action vigorously and Avanex believes that the resolution of this action will not have a material adverse effect on its business or financial condition.

In December 2004, the FASB issued Statement No. 153 (SFAS No.153), “Exchanges of Non-monetary Assets, an amendment of APB Opinion No. 29. SFAS No. 153 addresses the measurement of exchanges of non-monetary assets and redefines the scope of transactions that should be measured based on the fair value of the assets exchanged. SFAS No. 153 is effective for non-monetary asset exchanges beginning in our first quarter of fiscal 2006. We do not believe adoption of SFAS No. 153 will have a material effect on our consolidated financial position or results of operations.

In November 2004, the FASB issued SFAS No. 151, “Inventory Costs, an amendment of ARB No. 43, Chapter 4,” which amends the guidance in ARB No. 43, Chapter 4, “Inventory Pricing” to clarify the accounting for abnormal amounts of idle facility expense, freight, handling costs and spoilage. This statement now requires that these costs be expensed as current period charges. In addition, this statement requires that the allocation of fixed production overhead to the costs of conversion be based on the normal capacity of the production facilities. The provisions of this statement are effective for inventory costs incurred during fiscal years beginning after June 15, 2005. The Company has not yet assessed the impact of this statement on the Company’s financial position or results of operations.

On April 25, 2005, the Company’s Board of Directors approved a work force reduction plan that will result in the termination of approximately 150 full time employees at its France facility, leaving approximately 150 employees, in order to reduce operating expenses and improve the Company’s cost structure. The reduction in force is expected to be completed by the end of January 2006. The costs associated with this restructuring primarily consist of severance costs. The Company’s preliminary estimate of such costs is $26.0 million, all of which will result in cash expenditures disbursed over the next 15 months. The accrual for these costs will be recorded in the quarter ending June 30, 2005.

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Certain statements contained in this Quarterly Report on Form 10-Q that are not purely historical are “forward-looking statements” within the meaning of the federal securities laws, including, without limitation, our anticipated operating expenses, anticipated savings from our restructuring plans, and statements regarding our expectations, beliefs, anticipations, commitments, intentions and strategies regarding the future. In some cases, forward-looking statements can be identified by terms such as “may,” “could,” “would,” “might,” “will,” “should,” “expect,” “plan,” “intend,” “forecast,” “anticipate,” “believe,” “estimate,” “predict,” “potential,” “continue” or the negative of these terms or other comparable terminology. Actual results could differ from those projected in any forward-looking statements for the reasons, among others, detailed in “Factors That May Affect Future Results.” The forward-looking statements are made as of the date of this Form 10-Q and we assume no obligation to update the forward-looking statements, or to update the reasons why actual results could differ from those projected in the forward-looking statements.

The following discussion and analysis should be read in conjunction with the condensed consolidated financial statements and the notes thereto included in Item 1 of this Quarterly Report on Form 10-Q and our audited consolidated financial statements and notes for the year ended June 30, 2004, included in our Annual Report on Form 10-K filed with the SEC on September 13, 2004.

The telecommunications industry has been in a significant period of consolidation following a dramatic slowdown in equipment spending since late 2001. We acquired the optical components businesses of Alcatel and Corning on July 31, 2003 in transactions accounted for as a purchase. In addition, we acquired certain assets of Vitesse Semiconductor’s Optical Systems Division on August 28, 2003 in a transaction accounted for as a purchase. The Condensed Consolidated Statements of Operations for the nine months ended March 31, 2004 include eight months of operating results from the business activities and assets acquired from Alcatel and Corning on July 31, 2003 and seven months of operating results from the business activities and assets acquired from Vitesse on August 28, 2003.

Our consolidated financial statements also account for the sale of our planar lightwave circuit unit in Livingston, Scotland as a discontinued operation under GAAP as a result of our disposition of the business in February 2004. Our Condensed Consolidated Statements of Operations have been reformatted for the three and nine months ended March 31, 2004 to separate the results of the discontinued operation from the results of our continuing operations. This presentation is required by GAAP and facilitates historical and future trend analysis of our continuing operations. Unless otherwise indicated, the following discussion relates to our continuing operations.

Like many of our competitors, we continue to be adversely affected by the downturn in the telecommunications industry, and restructuring and cost-cutting measures are a significant focus for us. Over the past several years, we have implemented various restructuring programs to realign resources in response to the changes in the industry and customer demand. In addition, we assumed restructuring liabilities with fair values of $64.1 million at the date of acquisition through the acquisitions of the optical components businesses of Alcatel and Corning, which were included in the purchase price. Subsequent to these acquisitions, we have continued to restructure our organization, primarily through the downsizing of our workforce. During the first nine months of fiscal 2005, we approved work force reduction plans that would result in the termination of an additional 132 employees in order to reduce operating expenses by $8 million to $12 million and improve our cost structure. This reduction in force is expected to be completed by the end of November 2005. The costs associated with this restructuring consist of severance costs. Our preliminary estimate of such costs is $4.2 million. In addition, on April 25, 2005, we approved a work force reduction plan that will result in the termination of approximately 150 full time employees at our facility in France, leaving approximately 150 employees, in order to reduce operating expenses and improve our cost structure. The reduction in force is expected to be completed by the end of January 2006. The costs associated with this restructuring primarily consist of severance costs. Our preliminary estimate of such costs is approximately $26.0 million, all of which will result in cash expenditures disbursed over the next 15 months. The accrual for these costs will be recorded in the quarter ending June 30, 2005. The restructuring of French operations, coupled with the elimination of certain licensing fees of approximately $5.0 million, is expected to reduce operating costs by up to $28 million per year when fully implemented.

The restructurings have resulted and will result in, among other things, a significant reduction in the size of our workforce, consolidation of our facilities and increased reliance on outsourced, third-party manufacturing. In March 2005, we

announced that we had opened an Operations Center in Thailand to centralize global manufacturing and operational overhead functions in a low-cost region. Upon execution of the announced restructuring plans and the related transition to an Operations Center in Thailand, we believe that our current integration plans will be near completion. However, there can be no assurance that our cost structure will not increase in future quarters. In February 2004, we sold our planar lightwave circuit unit acquired from Alcatel, which was located in Livingston, Scotland, and accounted for it as a discontinued operation.

Revenue. The market for photonic processors is new and evolving and the volume and timing of orders is difficult to predict. A customer’s decision to purchase our products typically involves a commitment of its resources and a lengthy evaluation and product qualification process. This initial evaluation and product qualification process typically takes several months and includes technical evaluation, integration, testing, planning and implementation into the equipment design. Implementation cycles for our products, and the practice of customers in the communications industry to sporadically place orders with short lead times, may cause our revenues, gross margins, operating results and the identity of our largest customers to vary significantly and unexpectedly from quarter to quarter.

To date, our revenues have been principally derived from the sales of our products, which were significantly enhanced by the acquisitions of the optical component businesses of Alcatel and Corning. Revenues from our two product groups, Active Optical Solutions and Passive Optical Solutions, accounted for 73% and 27% of our net revenues in the three months ended March 31, 2005, 62% and 38% of our net revenues in the three months ended March 31, 2004, 78% and 22% of our net revenues in the nine months ended March 31, 2005 and 64% and 36% of our net revenues in the nine months ended March 31, 2004.

To date, a substantial proportion of our sales has been concentrated with a limited number of customers. For the three months ended March 31, 2005, sales to Alcatel, Ciena, and Cisco Systems accounted for 32%, 13% and 10%, respectively of net revenues, compared with sales to Alcatel, Cisco Systems and Nortel, which accounted for 30%, 22%, and 15%, of net revenues for the same period in the prior fiscal year. For the nine months ended March 31, 2005, sales to Alcatel accounted for 36% of net revenues, compared with sales to Alcatel and Cisco Systems, which accounted for 29% and 22%, of net revenues for the same period in the prior fiscal year. The preceding customer sales figures include sales to their contract manufacturers. While primarily as a result of the acquisitions of the optical components businesses of Alcatel and Corning, we have substantially diversified our customer base, we expect that a substantial portion of our sales will remain concentrated with a limited number of customers.

Cost of Revenue. Our cost of revenue consists of costs of components and raw materials, direct labor, warranty, manufacturing overhead, payments to our contract manufacturers and inventory write-offs for obsolete and excess inventory. We rely on a single or limited number of suppliers to manufacture some key components and raw materials used in our products, and we rely on the outsourcing of some subassemblies.

Research and Development Expenses. Research and development expenses consist primarily of salaries and related personnel costs, fees paid to consultants and outside service providers, costs of allocated facilities, non-recurring engineering charges and prototype costs related to the design, development, testing, pre-manufacturing and significant improvement of our products. We expense our research and development costs as they are incurred. We believe that research and development is critical to our strategic product development objectives. We further believe that, in order to meet the changing requirements of our customers, we must continue to fund investments in several development projects in parallel.

Sales and Marketing Expenses. Sales and marketing expenses consist primarily of commissions, marketing, sales, customer service and application engineering support, allocated facilities, as well as costs associated with promotional and other marketing expenses.

General and Administrative Expenses. General and administrative expenses consist primarily of salaries and related expenses for executive, finance, accounting, legal and human resources personnel, costs of allocated facilities, recruiting expenses, professional fees and other corporate expenses.

Stock Compensation. In connection with the grant of stock options to employees prior to our initial public offering and certain grants subsequent to our initial public offering, we recorded deferred stock compensation representing the difference between the fair value of our common stock for accounting purposes and the exercise price of these options at the date of grant. Moreover, in connection with the assumption of unvested stock options previously granted to employees of companies we acquired, we recorded deferred compensation representing the difference between the fair market value of our common stock on the date of closing of each acquisition and the exercise price of options granted by those companies which we assumed. Deferred stock compensation is presented as a reduction of stockholders’ equity, with accelerated amortization net of recoveries recorded over the vesting period, which is typically three to five years. The amount of deferred stock compensation expense to be recorded in future periods could decrease if options for which accrued but unvested compensation has been recorded are forfeited prior to vesting. The amount will also be affected by our implementation of SFAS 123R. See Note 3 of Notes to Condensed Consolidated Financial Statements.

Amortization of Intangible Assets. A portion of the purchase price in a business combination is allocated to goodwill and intangibles. Goodwill is not amortized, but rather is assessed for impairment at least annually. Intangible assets with definite lives continue to be amortized over their estimated useful lives.

Restructuring Charges. Restructuring charges generally include termination costs for employees and costs for excess manufacturing equipment and facilities associated with formal restructuring plans.

Gain on Disposal. Gain on disposals include gains incurred as a result of disposal of property, plant or equipment for an amount greater than the net book value.

Merger Costs. Merger costs include expenses incurred in connection with transactions that were not completed.

Interest and Other Income. Interest and other income consists primarily of interest earned from the investment of our cash.

Interest and Other Expense. Interest and other expense consists primarily of interest expense associated with borrowings under our line of credit, capital lease obligations and equipment loans and foreign currency exchange rate loss.

Loss from Discontinued Operations. Loss from discontinued operations consists of the net loss from our silica planar lightwave circuit (“PLC”) operation in Livingston, Scotland that was sold to Gemfire Corporation in February 2004.

The preparation of our consolidated financial statements in accordance with U.S. generally accepted accounting principles (“GAAP”) requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosures. We believe our estimates and assumptions are reasonable; however, actual results and the timing of the recognition of such amounts could differ from these estimates. We believe the following critical accounting policies affect our more significant judgments and estimates used in the preparation of our consolidated financial statements.

Liquidity. During the nine months ended March 31, 2005 and 2004, we incurred net losses of $65.6 million and $102.4 million, respectively, and our balance of cash, cash equivalents and unrestricted short and long-term investments declined from $122.4 million at June 30, 2004 to $54.5 million at March 31, 2005. These factors cast substantial uncertainty on our ability to continue as an ongoing enterprise for a reasonable period of time. Our ability to continue as an ongoing enterprise in its current configuration is dependent on us securing additional funding. The financial statements do not include any adjustments relating to the recoverability and classification of recorded asset amounts or the amounts and classification of liabilities that might be necessary should we be unable to continue as an ongoing enterprise.

Revenue Recognition. Our revenue recognition policy follows SEC Staff Accounting Bulletin (SAB) No. 104, “Revenue Recognition in Financial Statements” and Emerging Issues Task Force Abstract 00-21, “Revenue Arrangements with Multiple Deliverables.” Specifically, we recognize product revenue when persuasive evidence of an arrangement exists, the product has been shipped, title has transferred, collectibility is reasonably assured, fees are fixed or determinable and there are no uncertainties with respect to customer acceptance. We record a provision for estimated sales returns in the same period as the related revenues are recorded which is netted against revenue. These estimates are based on historical sales returns, other known factors and our return policy. If future sales returns differ from the historical data we use to calculate these estimates, changes to the provision may be required.

Allowance for Doubtful Accounts. We maintain an allowance for doubtful accounts for estimated losses resulting from the failure of our customers to make required payments. When we become aware, subsequent to delivery, of a customer’s potential inability to meet its obligations, we record a specific allowance for doubtful accounts. For all other customers, we record an allowance for doubtful accounts based on the length of time the receivables are past due. If the financial condition of our customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required. This may be magnified due to the concentration of our sales to a limited number of customers.

Excess and Obsolete Inventory. We make inventory commitment and purchase decisions based in part upon sales forecasts. To mitigate component supply constraints that have existed in the past and to fill orders with non-standard configurations, we build inventory levels for certain items with long lead times and enter into short-term commitments for certain items. We write off 100% of the cost of inventory that we specifically identify and consider obsolete or excessive to fulfill future sales estimates. If we subsequently sell previously written-off inventory, we will recognize revenue with no related cost of sales. We define obsolete inventory as inventory that will no longer be used in the manufacturing process. Excess inventory is generally defined as inventory in excess of projected usage, and is determined using our best estimate of future demand at the time, based upon information then available to us.

In estimating excess inventory, we currently use a six-month to twelve-month demand forecast depending upon visibility of demand from our customers. We also consider: (1) parts and subassemblies that can be used in

alternative finished products, (2) parts and subassemblies that are unlikely to be engineered out of our products, and (3) known design changes which would reduce our ability to use the inventory as planned. If either our demand forecast or estimate of future uses of inventory is inaccurate, we may need to make additional write-offs of inventory in future periods or achieve additional future favorable margins if we utilize previously written off inventory in those future periods.

Impairment of Long-Lived Assets Including Goodwill and Other Intangible Assets. We review long-lived assets other than goodwill and indefinite lived intangible assets for impairment whenever events or changes in business circumstances indicate that the carrying amount of the assets may not be fully recoverable, such as a significant industry downturn, significant decline in our market value or significant reductions in projected future cash flows. An impairment loss would be recognized when estimated undiscounted future cash flows expected to result from the use of the asset and its eventual disposition is less than its carrying amount. Impairment, if any, is assessed using discounted cash flows. In assessing the recoverability of long-lived assets other than goodwill and indefinite lived intangible assets we must make assumptions regarding estimated future cash flows and other factors to determine the fair value of the respective assets. If circumstances arise that cause these estimates or their related assumptions to change in the future we may be required to record additional impairment charges for these assets.

Goodwill is reviewed for impairment annually and as impairment indicators arise. Goodwill is tested for impairment at the reporting unit level utilizing a two-step methodology. The initial step requires us to determine the fair value of each reporting unit and compare it to the carrying value, including goodwill, of such unit. We believe we operate as one reporting unit. If the fair value of the reporting unit exceeds the carrying value, no impairment loss would be recognized. However, if the carrying value of the reporting unit exceeds its fair value, the goodwill of this unit may be impaired. The amount, if any, of the impairment would then be measured in the second step.

The fair value of the reporting unit is determined using the income approach. The income approach focuses on the income-producing capability of an asset, measuring the current value of the asset by calculating the present value of its future economic benefits such as cash earnings, cost savings, tax deductions, and proceeds from disposition. Value indications are developed by discounting expected cash flows to their present value at a rate of return that incorporates the risk-free rate for the use of funds, the expected rate of inflation, and risks associated with the particular investment. In response to changes in industry and market conditions, we may be required to strategically realign our resources and consider restructuring, disposing, or otherwise exiting businesses, which could result in an impairment of goodwill.

Warranties. We accrue for the estimated cost to provide warranty services at the time revenue is recognized. The specific terms and conditions of our warranties vary by customer and region in which we do business. Our estimate of costs to service our warranty obligations is based on historical experience and expectation of future conditions. To the extent we experience increased warranty claim activity or increased costs associated with servicing those claims, our warranty costs will increase resulting in decreases to gross profit.

Restructuring. We have recorded significant accruals in connection with our restructuring programs. These accruals include estimates pertaining to employee separation costs and related abandonment of excess equipment and facilities and potential costs and expenses associated with litigation brought against Avanex France S.A. by certain former employees. Actual costs may differ from these estimates or our estimates may change.

Purchase Accounting. We account for business combinations under the purchase method of accounting and accordingly, the assets acquired and liabilities assumed are recorded at their respective fair values. The recorded values of assets and liabilities are based on third-party and internal estimates and valuations. The values are based on our judgments and estimates, and accordingly, our financial position or results of operations may be affected by changes in these estimates and judgments.

Contingencies. We are subject to proceedings, lawsuits and other claims related to our initial public offering and other matters. We are required to assess the likelihood of any adverse judgments or outcomes to these matters as well as potential ranges of probable losses. A determination of the amount of accrual required, if any, for these contingencies is made after careful analysis of each individual issue and consultation with legal counsel. The required accrual may change in the future due to new developments in each matter or changes in approach such as a change in settlement strategy in dealing with these matters, resulting in higher net loss.

The results for the nine months ended March 31, 2004 include eight months of operating results from the business activities and assets acquired from Alcatel and Corning on July 31, 2003 and seven months of operating results from the business activities and assets acquired from Vitesse on August 28, 2003.

The following table sets forth, for the periods indicated, the results of our operations expressed as a percentage of net revenue. Our historical operating results are not necessarily indicative of our results for any future period.

Net revenue for the quarter ended March 31, 2005 was $40.3 million, which represents an increase of $10.2 million, or 34%, from net revenue of $30.1 million for the quarter ended March 31, 2004. This increase in net revenue was primarily due to increased shipments of our Active Optical Solutions products, which includes transmission, amplification and network managed subsystems products, slightly offset by decreased shipments of our Passive Optical Solutions products. The increased shipments were due to increased demand from existing customers, coupled with an increased customer base. The increase was also partially offset by a modest decrease in average selling prices primarily due to annual product pricing negotiations and increased competition from low cost providers. If price declines continue, our net revenue will be adversely impacted. For the quarters ended March 31, 2005 and 2004 our Active Optical Solutions products comprised 73% and 62%, respectively, of our net revenues. Our Passive Optical Solutions products comprised 27% and 38% of our net revenues for the quarters ended March 31, 2005 and 2004, respectively.

Net revenue for the nine months ended March 31, 2005 was $118.0 million, which represents an increase of $42.9 million, or 57%, from net revenue of $75.1 million for the nine months ended March 31, 2004. This increase in net revenue was primarily due to increased shipments of our Active Optical Solutions products, which includes transmission, amplification and network managed subsystems products, slightly offset by decreased shipments of our Passive Optical Solutions products. The increased shipments were due to increased demand from existing customers, coupled with an increased customer base. The increase was also partially offset by a modest decrease in average selling prices primarily due to annual product pricing negotiations and increased competition from low cost providers. For the nine months ended March 31, 2005 and 2004 our Active Optical Solutions products comprised 78% and 64%, respectively, of our net revenues. Our Passive Optical Solutions products comprised 22% and 36% of our net revenues for the nine months ended March 31, 2005 and 2004, respectively.

Net revenue from sales to customers outside the United States accounted for $24.3 million, or 60%, and $16.1 million, or 54%, for the quarters ended March 31, 2005 and 2004, respectively. Net revenue from sales to customers outside the United States accounted for $71.4 million, or 61%, and $37.3 million, or 50%, for the nine months ended March 31, 2005 and 2004, respectively.

Cost of revenue for the quarter ended March 31, 2005 was $41.4 million, compared to $36.3 million for the quarter ended March 31, 2004, an increase of $5.1 million. Cost of revenue for the nine months ended March 31, 2005 was $122.4 million, compared to $96.2 million for the nine months ended March 31, 2004, an increase of $26.2 million. The increases in both the three and nine months ended March 31, 2005 were primarily due to increased revenue and a $4.7 million write-down for excess inventory primarily due to discontinued products.

We sold inventory previously written-off with original cost totaling $43,000 and $158,000 in the quarters ended March 31, 2005 and 2004, respectively, due to unforeseen demand for such inventory. We sold inventory previously written-off with original cost totaling $605,000 and $1.0 million in the nine months ended March 31, 2005 and 2004, respectively, due to unforeseen demand for such inventory. As a result, cost of revenue associated with the sale of this inventory was zero. The selling price of the finished goods that included these components was similar to the selling price of products that did not include components that were written-off. These items were subsequently used and sold because customers ordered products that included these components in excess of our estimates. Cost of revenue in the quarters ended March 31, 2005 and 2004 was also offset by $380,000 and $14,000, respectively, for reductions of the pre-existing warranty accrual. Cost of revenue in the nine months ended March 31, 2005 and 2004 also was offset by $0.8 million and $1.4 million, respectively, for reductions of the accrual for pre-existing warranties.

Our gross margin percentage improved to negative 3% for the quarter ended March 31, 2005 from negative 21% for the quarter ended March 31, 2004. Our gross margin percentage improved to negative 4% for the nine months ended March 31, 2005 from negative 28% for the nine months ended March 31, 2004. These improvements are primarily due to cost reductions in connection with our restructuring efforts, as well as a favorable product mix attributable to an increase in sales volume of our long-haul active product line with low product costs. These improvements were partially offset by startup costs associated with the opening of our Operations Center in Thailand.

We continue to experience negative gross margins due to underutilized manufacturing capacity at our facilities. We have in the past incurred and may in the future incur additional costs as we transition to offshore and third-party manufacturing. Our gross margins are and will be primarily affected by changes in mix of products sold including inventory items with low product costs, manufacturing volume, changes in market prices, product demand, inventory write-offs, consumption of previously written-off inventory, warranty costs, and product yield. We expect cost of revenue, as a percentage of net revenue, to fluctuate from period to period. In addition, we expect continued pressure on our gross margin percentage as a result of underutilized manufacturing capacity and price competition.

Research and development expenses decreased $2.1 million to $8.6 million for the quarter ended March 31, 2005 from $10.7 million for the quarter ended March 31, 2004. Since the acquisition of the optical components businesses of Alcatel and Corning, we have decreased our research and development expenses through cost reduction programs, including reducing headcount and reducing project expenses by integrating our sites. As a percentage of revenue, research and development expenses decreased to 21% for the quarter ended March 31, 2005 from 36% in the quarter ended March 31, 2004. Research and development expenses decreased $6.4 million to $24.8 million for the nine months ended March 31, 2005 from $31.2 million for the nine months ended March 31, 2004. As a percentage of revenue, research and development expenses decreased to 21% for the nine months ended March 31, 2005 from 42% in the nine months ended March 31, 2004. We expect our quarterly research and development expenses in the fourth quarter of fiscal 2005 to decrease from the third quarter of fiscal 2005 as a percentage of revenue. Despite our continued efforts to reduce expenses, there can be no assurance that our research and development expenses will not increase in future quarters.

Sales and marketing expenses decreased $1.0 million to $4.1 million for the quarter ended March 31, 2005 from $5.1 million for the quarter ended March 31, 2004. As a percentage of revenue, sales and marketing expenses decreased to 10% in the quarter ended March 31, 2005 from 17% in the quarter ended March 31, 2004. The decrease in sales and marketing

expense during this period was primarily due to decreased headcount and tradeshow expenses. Sales and marketing expenses decreased $1.5 million to $13.0 million for the nine months ended March 31, 2005 from $14.5 million for the nine months ended March 31, 2004. The decrease in sales and marketing expenses during this period was primarily due to decreased headcount, travel expenses and marketing expenses. As a percentage of revenue, sales and marketing expenses decreased to 11% in the nine months ended March 31, 2005 from 19% in the nine months ended March 31, 2004. We expect our quarterly sales and marketing expenses in the fourth quarter of fiscal 2005 to be approximately the same as our sales and marketing expenses for the third quarter of fiscal 2005 as a percentage of revenue. There can be no assurance that our sales and marketing expense will not increase in the future or that we will develop a cost structure (including sales and marketing), which will lead to profitability under current and expected revenue levels.

General and administrative expenses decreased $3.4 million to $4.4 million for the quarter ended March 31, 2005 from $7.8 million for the quarter ended March 31, 2004. As a percentage of revenue, general and administrative expenses decreased to 11% in the quarter ended March 31, 2005 from 26% in the quarter ended March 31, 2004. General and administrative expenses decreased $6.2 million to $13.0 million for the nine months ended March 31, 2005 from $19.3 million for the nine months ended March 31, 2004. As a percentage of revenue, general and administrative expenses decreased to 11% in the nine months ended March 31, 2005 from 26% in the nine months ended March 31, 2004. Since the acquisition of the optical components businesses of Alcatel and Corning, we have decreased our general and administrative expenses through cost reduction programs, primarily by reducing headcount. In addition, our transitional expenses related to the acquisitions, our legal expenses and our payroll costs for the three and nine months ended March 31, 2005 are less than such costs compared to the three and nine months ended March 31, 2004. We expect our quarterly general and administrative expenses in the fourth quarter of fiscal 2005 to be approximately the same as our general and administrative expenses for the third quarter of fiscal 2005 as a percentage of revenue. There can be no assurance that our general and administrative expenses will not increase in the future or that we will develop a cost structure (including general and administrative), which will lead to profitability under current and expected revenue levels.

Stock compensation expense decreased to $53,000 for the quarter ended March 31, 2005 compared to $135,000 for quarter ended March 31, 2004. Stock compensation decreased $444,000 to $293,000 for the nine months ended March 31, 2005 from $737,000 for the nine months ended March 31, 2004. From inception through March 31, 2005, we have expensed a total of $102.9 million of stock compensation, leaving an unamortized balance of $404,000 on our March 31, 2005 balance sheet. The decrease in stock compensation expense was primarily attributable to employee terminations during the quarter ended March 31, 2005. Stock compensation expense is recorded under APB Opinion No. 25 and accordingly no compensation expense is recognized when the exercise price of our employee stock options equals the market price of the underlying stock on the date of grant. Under the new rules, SFAS 123R, all shared-based payments to employees, including grants of employee stock options, are to be expensed in the financial statements starting July 1, 2005. We believe that the impact will be significant to net loss, but we will not know the full impact on the financial statements until it is implemented. Additionally, upon implementation, stock compensation and the amount required by SFAS 123R will not be separately stated in the income statement.

The balance of intangibles on our consolidated balance sheet as of March 31, 2005 was $10.7 million arising from the acquisitions of the optical components businesses of Alcatel, Corning and Vitesse. Amortization of these intangible assets was $1.2 million and $1.3 million for the quarters ended March 31, 2005 and March 31, 2004, respectively. Amortization of these intangible assets increased $421,000 to $3.7 million for the nine months ended March 31, 2005 from $3.3 million for the nine months ended March 31, 2004. The increase was due to a full nine months of amortization in the first half of fiscal year 2005 compared to eight months in fiscal year 2004.

Over the past several years, we have implemented various restructuring programs to realign resources in response to the changes in our industry and customer demand, and we continue to assess our current and future operating requirements accordingly.

During the first nine months of fiscal 2005, we approved work force reduction plans that would result in the termination of an additional 132 employees in order to reduce operating expenses by $8 million to $12 million and improve our cost structure. This reduction in force is expected to be completed by the end of November 2005. The costs associated

with this restructuring consist of severance costs. Our estimate of such costs is approximately $4.2 million. In addition, on April 25, 2005, we approved a work force reduction plan that will result in the termination of approximately 150 full time employees at our facility in France, leaving approximately 150 employees, in order to reduce operating expenses and improve our cost structure. The reduction in force is expected to be completed by the end of January 2006. The costs associated with this restructuring primarily consist of severance costs. Our preliminary estimate of such costs is approximately $26.0 million, all of which will result in cash expenditures disbursed over the next 15 months. The accrual for these costs will be recorded in the quarter ending June 30, 2005. The restructuring of French operations, coupled with the elimination of certain licensing fees of approximately $5.0 million, is expected to reduce operating costs by up to $28 million per year when fully implemented.

During fiscal year 2004, we announced and implemented several restructuring programs throughout the organization, primarily downsizing our workforce by approximately 450 employees in our manufacturing operations.

During fiscal year 2003, we announced the closing of our facility in Richardson, Texas and the integration of the functions in Richardson into its facility in Fremont, California. During fiscal 2004 and 2005, we continued to downsize our workforce, primarily in our manufacturing operations, and further consolidated our facilities in Fremont.

In connection with proposed acquisition activity, in the nine months ended March 31, 2005 we expensed $300,000 in related merger costs for a proposed acquisition that did not proceed.

Interest and other income decreased $562,000 to $498,000 in the quarter ended March 31, 2005 from $1.1 million in the quarter ended March 31, 2004. This decrease was primarily due to decreased cash and investment balances and lower interest rates. Interest and other income decreased $1.7 million to $1.7 million in the nine months ended March 31, 2005 from $3.4 million in the nine months ended March 31, 2004. This decrease was primarily due to decreased cash and investment balances and lower interest rates.

Interest and other expense decreased $234,000 to $257,000 in the quarter ended March 31, 2005 from $491,000 in the quarter ended March 31, 2004. This decrease was primarily due to lower interest expense resulting from lower debt levels. Interest and other expense increased $367,000 to $1.5 million in the nine months ended March 31, 2005 from $1.1 million in the nine months ended March 31, 2005. The increase was primarily due to foreign currency exchange losses.

In February 2004, we entered into a share acquisition agreement with Gemfire Corporation (“Gemfire”) pursuant to which Gemfire acquired our silica planar lightwave circuit (“PLC”) product line manufactured in Livingston, Scotland, which was acquired in our acquisition of Alcatel Optronics in the first quarter of fiscal 2004. During the nine months ended March 31, 2004, we recorded a net loss from discontinued operations of $6.1 million.

In February 2000, we received net proceeds of approximately $238.0 million from the initial public offering of our common stock and a concurrent sale of stock to corporate investors. Subsequent to our initial public offering, we have financed our operations through the sale of equity securities, bank borrowings, equipment lease financings, acquisitions and other strategic transactions. In connection with the acquisitions of the optical components business of Alcatel and Corning on July 31, 2003, Corning and Alcatel contributed cash, cash equivalents and short-term investments of $128.6 million and we assumed liabilities of $124.2 million.

In November 2003, we entered into a securities purchase agreement pursuant to which the investors named therein purchased, in the aggregate, 6,815,555 shares of our common stock at a price of $4.63 per share for aggregate gross proceeds of approximately $31.5 million. Net proceeds from this transaction amounted to approximately $29.6 million after payment of fees to financial and legal advisors and other direct costs. In connection with the issuance of the shares of common stock, the investors were issued rights, which were exercisable for up to an additional 1,363,116 shares of our common stock at $4.63 per share. During the third quarter of fiscal 2004, 192,584 shares of common stock were issued upon the exercise of certain of such rights. The remainder of these rights expired on March 16, 2004.

In February 2004, we entered into a securities purchase agreement pursuant to which the purchasers named therein purchased, in the aggregate, 7,319,761 shares of our common stock at a price of $5.49 per share for aggregate gross proceeds

of approximately $40.2 million. Net proceeds from this transaction amounted to approximately $38.7 million after payment of fees to financial and legal advisors and other direct costs. In connection with the issuance of the shares of common stock, the investors were issued rights which are exercisable for up to an additional 1,463,954 shares of our common stock at $5.49 per share. None of these rights were exercised, and the rights expired on June 9, 2004.

As of March 31, 2005, we had cash and cash equivalents and short-term investments of $42.4 million and long-term investment holdings of $29.4 million for a combined total of $71.8 million. This decrease of $72.4 million from June 30, 2004 was primarily due to cash consumed in operations of $50.3 million, a $20.7 million investment in working capital and purchases of property, plant and equipment of $2.9 million, partially offset by proceeds from the exercise of stock options of $1.3 million and sale of equipment of $2.9 million.

Our working capital investment of $20.7 million was substantially a result of increases of $3.8 million in receivables and $4.5 million in inventory to support increased revenues, and a $8.5 million increase in accrued restructuring costs payable in cash over the next twelve months.

Net cash provided by investing activities was $59.2 million in the nine months ended March 31, 2005. Net cash provided by investing activities was primarily the result of maturities of held-to-maturity securities and proceeds from the sale of equipment, offset by costs incurred in the purchases of other investments and purchases of property and equipment.

Net cash used by financing activities was $2.4 million in the nine months ended March 31, 2005, primarily the result of payments on short-term debt, long-term debt and capital lease obligations offset by proceeds from issuance of common stock related to our employee stock option plans and employee stock purchase plan.,

During the nine months ended March 31, 2005 and 2004, we incurred net losses of $65.6 million and $102.4 million, respectively, and our balance of cash, cash equivalents and unrestricted short and long-term investments declined from $122.4 million at June 30, 2004 to $54.5 million at March 31, 2005. These factors cast substantial uncertainty on our ability to continue as an ongoing enterprise for a reasonable period of time. Our ability to continue as an ongoing enterprise in its current configuration is dependent on us securing additional funding. The financial statements do not include any adjustments relating to the recoverability and classification of recorded asset amounts or the amounts and classification of liabilities that might be necessary should we be unable to continue as an ongoing enterprise.

As of April 30, 2005 our cash, cash equivalents and short and long-term investments were approximately $62.6 million, which includes $17.3 million of cash and investments restricted as collateral on the Company’s line of credit. Additionally, we have a revolving line of credit from a financial institution, which allows maximum borrowings up to $10.0 million through January 1, 2006, of which $3.9 million was drawn down and $2.7 million was pledged to secure letters of credit at March 31, 2005. The line of credit requires us to comply with specified covenants. We are in compliance with all the covenants at March 31, 2005. The line bears interest at the prime rate plus 1.25%. At March 31, 2005 the effective interest rate was 7.0%. We have pledged all of our assets as collateral for this line. We believe that if we are unable to renew the line of credit it will have a significant impact on our liquidity.

In addition, from time to time, we may also consider the acquisition of, or evaluate investments in, products and businesses complementary to our business. An acquisition or investment may require additional capital. The significant contraction in the capital markets, particularly in the technology sector, may make it difficult for us to raise additional capital when it is required, especially if we experience disappointing operating results. If adequate capital is not available to us as required, or is not available on favorable terms, our business, financial condition and results of operations will be adversely affected.

Our contractual obligations and commitments at March 31, 2005 have been summarized in the tables below (in thousands):

We have unconditional purchase obligations to certain of our suppliers and contract manufacturers that support our ability to manufacture our products. As of March 31, 2005, we had approximately $32.7 million of purchase obligations, $668,000 to related parties, none of which is included on our balance sheet in accounts payable.

Under operating and capital leases described in the table above, we have included total future minimum rent expense under non-cancelable leases for both current and abandoned facilities and equipment leases. We have included in the balance sheet $4.9 million and $10.3 million in current and long-term restructuring accruals, respectively, for the abandoned facilities as of March 31, 2005. The tables listed above do not include amounts related to the restructuring announced on April 25, 2005.

On December 16, 2004 the Financial Accounting Standards Board issued FASB Statement No. 123R: “Share-Based Payment” (“SFAS 123R”), which is a revision of FASB Statement No. 123, Accounting for Stock-Based Compensation. SFAS 123R supersedes APB Opinion No. 25, Accounting for Stock Issued to Employees, and amends FASB Statement No. 95, Statement of Cash Flows. Under SFAS 123R, all shared-based payments to employees, including grants of employee stock options, are to be expensed in the financial statements based on their fair value determined by applying a fair value measurement method. Regardless of which transition method a company selects, the cumulative effect of adopting SFAS 123R would be recognized on July 1, 2005. We will be required to implement SFAS 123R on July 1, 2005. We are currently evaluating the impact of the change in accounting in light of SFAS 123R. We believe that the impact will be significant to net loss but we will not know the full impact on the financial statements until it is implemented.

In December of 2004, the FASB issued Statement No. 153 (SFAS No.153), exchanges of Non-monetary Assets, an amendment of APB Opinion No. 29. SFAS No. 153 addresses the measurement of exchanges of non-monetary assets and redefines the scope of transactions that should be measured based on the fair value of the assets exchanged. SFAS No. 153 is effective for non-monetary asset exchanges beginning in our first quarter of fiscal 2006. We do not believe adoption of SFAS No. 153 will have a material effect on our consolidated financial position or results of operations.

In November 2004, the FASB issued SFAS No. 151, “Inventory Costs, an amendment of ARB No. 43, Chapter 4,” which amends the guidance in ARB No. 43, Chapter 4, “Inventory Pricing” to clarify the accounting for abnormal amounts of idle facility expense, freight, handling costs and spoilage. This statement now requires that these costs be expensed as current period charges. In addition, this statement requires that the allocation of fixed production overhead to the costs of conversion be based on the normal capacity of the production facilities. The provisions of this statement are effective for inventory costs incurred during fiscal years beginning after June 15, 2005. We have not yet assessed the impact of this statement on our financial position or results of operations.

In addition to the other information contained in this Quarterly Report on Form 10-Q, we have identified the following risks and uncertainties that may have a material adverse affect on our business, financial condition or results of operations. Investors should carefully consider the risks described below before making an investment decision. The risks described below are not the only ones we face. Additional risks not presently known to us or that we currently believe are immaterial may also impair our business operations. Our business could be harmed by any of these risks. The trading price of our common stock could decline due to any of these risks and investors may lose all or part of their investment. This section should be read in conjunction with the Consolidated Financial Statements and Notes thereto, and Management’s Discussion and Analysis of Financial Condition and Results of Operations contained in this Form 10-Q.

We have a history of negative cash flow and losses, which is likely to continue if we are unable to increase our revenues and further reduce our costs.

We have never been profitable. We have experienced operating losses in each quarterly and annual period since our inception in 1997, and we may continue to incur operating losses for the foreseeable future. As of March 31, 2005, we had an accumulated deficit of $577 million. Also, for the quarter and the nine months ended March 31, 2005, and each of our prior fiscal years, we had negative operating cash flow, and we expect to continue to incur negative operating cash flow in future periods. In addition, our acquisitions of the optical components businesses of Alcatel, Corning and Vitesse Semiconductor have increased our operating losses.

Due to insufficient cash generated from operations, we have funded our operations primarily through the sale of equity securities, bank borrowings, equipment lease financings, acquisitions and other strategic transactions. Although we implemented cost reduction programs in the nine months ended March 31, 2005 and fiscal year 2004, we continue to have significant fixed expenses, and we expect to continue to incur considerable manufacturing, sales and marketing, product development and administrative expenses. In addition, we completed our acquisitions of the optical components businesses of Alcatel and Corning in July 2003 and Vitesse in August 2003. The costs and operating expenses of the combined company are significantly greater than the costs and operating expenses of Avanex as a stand-alone company. As a result, the combined operations of Avanex and the optical components businesses of Alcatel, Corning and Vitesse have substantially increased the rate at which Avanex uses its cash resources. If we fail to generate higher revenues and increase our gross margins while containing our costs and operating expenses, our financial position will be harmed significantly. Our revenues may not grow in the future, and we may never generate sufficient revenues to achieve profitability.

If we do not reduce costs and improve our gross margins, our financial condition and results of operations will be adversely impacted.

Our ability to achieve profitability depends on our ability to control costs and expenses in relation to sales and to increase our gross margin. During the fiscal quarter ended March 31, 2005, the nine months ended March 31, 2005 and the fiscal year ended June 30, 2004, our gross margin percentage was negative 3%, negative 4% and negative 25%, respectively. Because the majority of our manufacturing costs is relatively fixed, our inability to maintain appropriate manufacturing capacity in relation to our sales negatively impacts our gross margin. We may not achieve manufacturing cost levels that will allow us to achieve acceptable gross margins.

As part of our cost reduction efforts, over the past several years we have implemented various restructuring programs to realign our resources in response to the changes in the industry and customer demand. We have initiated future restructuring actions, which will result in charges that have a material effect on our results of operations and our financial position. We may initiate future restructuring actions, which are likely to result in charges that could effect our results of operations or financial position. There can be no assurance that we will realize the benefits we anticipate from our current or future restructuring programs or that such programs will reduce our operating expenses and improve our cost structure.

In addition, over our limited operating history, the average selling prices of our products have decreased, and we expect this trend to continue. Future price decreases may be due to a number of factors, including competitive pricing pressures, rapid technological change and sales discounts. Therefore, to improve our gross margin, we must develop and introduce new products and product enhancements on a timely basis and reduce our costs of production. Moreover, as our average selling prices decline, we must increase our unit sales volume, or introduce new products, to maintain or increase our revenues. If our average selling prices decline more rapidly than our costs of production, our gross margin will decline, which could adversely impact our business, financial condition and results of operations. If we are unable to generate positive gross margins in the future, our cash flows from operations would be negatively impacted, and we would be unable to achieve profitability.

We may have difficulty obtaining additional capital because of reduced funding of and lending to companies in the optical components industry.

The optical components sector of the telecommunications industry, in which we operate, has been severely affected by the recent downturn in the global economy. As a result, companies in this sector have experienced difficulty in raising capital, whether through equity or debt financing transactions. During the nine months ended March 31, 2005 and 2004, we incurred net losses of $65.6 million and $102.4 million, respectively, and our balance of cash, cash equivalents and unrestricted short and long-term investments declined from $122.4 million at June 30, 2004 to $54.5 million at March 31, 2005. These factors cast substantial uncertainty on our ability to continue as an ongoing enterprise for a reasonable period of time. Our ability to continue as an ongoing enterprise in its current configuration is dependent on us securing additional funding. We expect to require additional financing to fund our operations in the next twelve months. It may be difficult for us to raise additional capital if and when it is required. If adequate capital is not available to us as required, or if it is not available on favorable terms, our business and financial condition would be adversely affected.

Our future revenues and operating results are inherently unpredictable, and as a result, we may fail to meet the expectations of securities analysts or investors, which could cause our stock price to decline.

Our revenues and operating results have fluctuated significantly from quarter-to-quarter in the past, and may continue to fluctuate significantly in the future. Factors that are likely to cause these fluctuations, some of which are outside of our control, include, without limitation, the following:

A high percentage of our expenses, including those related to manufacturing, engineering, sales and marketing, research and development, and general and administrative functions, is fixed in the short term. As a result, if we experience delays in generating and recognizing revenue, our quarterly operating results are likely to be seriously harmed.

Due to these and other factors, we believe that quarter-to-quarter comparisons of our operating results may not be meaningful. Our results for one quarter should not be relied upon as any indication of our future performance. It is possible that in future quarters our operating results may be below the expectations of public market analysts or investors. If this occurs, the price of our common stock would likely decrease.

We are required to evaluate our internal control under Section 404 of the Sarbanes-Oxley Act of 2002 and any adverse results from such evaluation could result in a loss of investor confidence in our financial reports and have an adverse effect on our stock price.

Pursuant to Section 404 of the Sarbanes-Oxley Act of 2002, beginning with our Annual Report on Form 10-K for the fiscal year ending June 30, 2005, we will be required to furnish a report by our management on our internal control over financial reporting. Such report will contain, among other matters, an assessment of the effectiveness of our internal control over financial reporting as of the end of our fiscal year, including a statement as to whether or not our internal control over financial reporting is effective. This assessment must include disclosure of any material weaknesses in our internal control over financial reporting identified by management. Such report must also contain a statement that our auditors have issued an attestation report on management’s assessment of such internal controls. Auditing Standard No. 2 provides the professional standards and related performance guidance for auditors to attest to, and report on, management’s assessment of the effectiveness of internal control over financial reporting under Section 404.

While we currently believe our internal control over financial reporting is effective we are still performing the system and process documentation and evaluation needed to comply with Section 404, which is both costly and challenging. During this process, if our management identifies one or more material weaknesses in our internal control over financial reporting as of June 30, 2005, we will be unable to assert such internal control is effective. If we are unable to assert that our internal control over financial reporting is effective as of June 30, 2005 (or if our auditors are unable to attest that our management’s report is fairly stated or they are unable to express an opinion on our management’s evaluation or on the effectiveness of the internal controls), we could lose investor confidence in the accuracy and completeness of our financial reports, which would have an adverse effect on our stock price, and our business and operating results could be harmed.

While we currently anticipate being able to satisfy the requirements of Section 404 in a timely fashion with respect to our existing business, we cannot be certain as to the timing of completion of our evaluation, testing and any required remediation due in large part to the fact that there is no precedent available by which to measure compliance with the new Auditing Standard No. 2.

In addition, our restructuring activities have included starting operations in a new location as we transition our manufacturing to a lower cost geography. Due to the timing of these restructuring efforts, it is possible that we will not satisfy the requirements of Section 404 in a timely manner with respect to these new operations. If we are not able to comply with the requirements of Section 404 in a timely manner or if our auditors are not able to complete the procedures required by Audit Standard No. 2 to support their attestation report, we would likely lose investor confidence in the accuracy and completeness of our financial reports, which would have an adverse effect on our stock price, and our business and operating results could be harmed.

The trading price of our common stock has fluctuated significantly since our initial public offering in February 2000, and is likely to remain volatile in the future. For example, during fiscal 2005, our common stock has closed as low as $0.98 and as high as $3.73 per share, and during fiscal 2004, our common stock has closed as low as $2.60 and as high as $7.40 per

share. The trading price of our common stock could be subject to wide fluctuations in response to many events or factors, including the following:

In addition, the stock market has experienced volatility that has particularly affected the market prices of equity securities of many high technology companies, which often has been unrelated or disproportionate to the operating performance of these companies. These broad market fluctuations may adversely affect the market price of our common stock. As long as we continue to depend on a limited customer base and a limited number of products, there is substantial risk that our quarterly results will fluctuate.

In July 2003, we issued an aggregate of 56,844,376 shares of our common stock to Alcatel and Corning Incorporated in connection with our acquisitions of the optical components businesses of Alcatel and Corning. Alcatel and Corning own shares of Avanex common stock representing 19.55% and 11.87%, respectively, of the outstanding shares of Avanex common stock as of May 2, 2005. In connection with these acquisitions, we entered into a stockholders’ agreement with Alcatel and Corning. Pursuant to the stockholders’ agreement, we registered 56,844,376 shares of common stock on behalf of Alcatel and Corning in July 2004. Subject to certain restrictions on transfer which apply for a period of two years following the completion of our acquisitions of the optical components businesses of Alcatel and Corning, Alcatel or Corning may sell substantial amounts of our common stock in the public market which could cause the market price of our common stock to fall, and could make it more difficult for us to raise capital through public offerings or other sales of our capital stock. Specifically, pursuant to the stockholders’ agreement, Alcatel and Corning may sell up to an aggregate of 11,368,875 shares of our common stock between April 1, 2005, and June 30, 2005. An aggregate of 34,106,627 shares of common stock beneficially owned by Alcatel and Corning will continue to be subject to restrictions on transfer pursuant to the stockholders’ agreement. After June 30, 2005, Alcatel and Corning will be permitted to dispose of an additional ten percent (10%) of the shares acquired from Avanex during the quarter ended September 30, 2005, subject to certain exceptions. If Alcatel, Corning or our other stockholders sell substantial amounts of our common stock in the public market during a short period of time, our stock price may decline significantly.

Financial statements are prepared in accordance with U.S. generally accepted accounting principles. These principles are subject to interpretation by various governing bodies, including the Financial Accounting Standards Board and the Securities and Exchange Commission, which interpret and create appropriate accounting regulations. A change from current accounting regulations could have a significant effect on our results of operations. For example, we currently account for our stock-based compensation plans under the recognition and measurement principles of Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees,” and related interpretations. In accordance with SFAS No. 123, “Accounting for Stock-Based Compensation,” in Note 3 of our Notes to Condensed Consolidated Financial Statements we also provide disclosures of our operating results as if we had applied the fair value method of accounting (pro-forma basis). On December 16, 2004, FASB issued FASB Statement No. 123R: “Share-Based Payment.” Under SFAS 123R, all shared-based payments to employees, including grants of employee stock options, are to be expensed in the financial statements

based on their fair value determined by applying a fair value measurement method. We would be required to implement SFAS 123R on July 1, 2005, and adoption of SFAS 123R will have a material adverse affect on our results of operations. For example, as reported in Note 3 of Notes to Condensed Consolidated Financial Statements, for the three and nine months ended March 31, 2005, if had we accounted for stock-based compensation plans using the fair-value method prescribed in FASB Statement No. 123, our net loss would have increased by $2.5 million and $14.0 million, respectively.

Market conditions in the telecommunications industry may significantly harm our financial position.

In the past several years, there has been a significant reduction in spending in the telecommunications industry. Certain large telecommunications companies who were customers or potential customers of ours have suffered severe business setbacks and face uncertain futures. There is currently a perception that an oversupply of communications bandwidth exists. This perceived oversupply, coupled with the current economic environment, may lead to the continuation of lower telecommunications spending, and our customers may continue to cancel, defer or significantly reduce their orders for our products.

We sell our products primarily to a few large customers in the telecommunications industry. Three customers accounted for an aggregate of 55% of our net revenue for the fiscal quarter ended March 31, 2005 and 54% of our net revenue for the nine months ended March 31, 2005. We expect that the majority of our revenues will continue to depend on sales of our products to a small number of customers. If current customers do not continue to place significant orders, or if they cancel or delay current orders, we may not be able to replace these orders. In addition, any negative developments in the business of existing customers could result in significantly decreased sales to these customers, which could seriously harm our revenues and results of operations. We have experienced, and in the future we may experience, losses as a result of the inability to collect accounts receivable, as well as the loss of ongoing business from customers experiencing financial difficulties. If our customers fail to meet their payment obligations, we could experience reduced cash flows and losses in excess of amounts reserved. Because of our reliance on a limited number of customers, any decrease in revenues from, or loss of, one or more of these customers without a corresponding increase in revenues from other customers would harm our operating results.

Our customers are under no obligation to buy significant quantities of our products, and may cancel or delay purchases with minimal advance notice to us.

Our customers typically purchase our products pursuant to individual purchase orders. While we have executed long-term contracts with some of our customers, and may enter into additional long-term contracts with other customers in the future, these contracts do not obligate our customers to buy significant quantities of our products, except for our supply agreement and frame purchase agreement with Alcatel. Our customers may cancel, defer or decrease purchases without significant penalty and with little or no advance notice. Further, certain of our customers have a tendency to purchase our products near the end of a fiscal quarter. Cancellation or delays of such orders may cause us to fail to achieve that quarter’s financial and operating goals. Decreases in purchases, cancellations of purchase orders, or deferrals of purchases may significantly harm our business, particularly if they are not anticipated.

We believe that our principal competitors in the optical systems and components industry include Bookham Technology, DiCon Fiberoptics, Eudyna, Finisar, Fujitsu, Furukawa, Hitachi Cable, JDS Uniphase, NEC, Oplink Communications and Opnext. We may also face competition from companies that expand into our industry in the future.

Some of our competitors have longer operating histories and significantly greater financial, technical, marketing and other resources than we have. As a result, some of these competitors are able to devote greater resources to the development, promotion, sale, and support of their products. In addition, our competitors that have larger market capitalization or cash reserves are better positioned than we are to acquire other companies in order to gain new technologies or products that may displace our product lines. Consolidation in the optical systems and components industry could intensify the competitive pressures that we face because these consolidated competitors may have longer operating histories and significantly greater financial, technical, marketing and other resources than we have. For example, three of our historical competitors, JDS Uniphase, SDL, and E-Tek Dynamics have merged over the past several years to become a single, more formidable competitor. This merged company has announced its intention to offer more integrated products that could make our products less competitive. More recently, Bookham Technology acquired the optical components business of Nortel and Marconi and has since become a stronger competitor.

Some existing customers and potential customers, as well as suppliers and potential suppliers, are also our competitors. These customers and suppliers may develop or acquire additional competitive products or technologies in the future, which

may cause them to reduce or cease their purchases from us or supply to us, as the case may be. Further, these customers may reduce or discontinue purchasing our products if they perceive us as a serious competitive threat with regard to sales of products to their customers. Additionally, suppliers may reduce or discontinue selling materials to us if they perceive us as a serious competitive threat with regard to sales of products to their customers. As a result of these factors, we expect that competitive pressures will intensify and may result in price reductions, reduced margins and loss of market share.

Competition in the optical systems and components industry has contributed to substantial price-driven competition. As a result, sales prices for specific products have decreased over time at varying rates, in some instances significantly. Price pressure is exacerbated by the rapid emergence of new technologies and the evolution of technical standards, which can greatly diminish the value of products relying on older technologies and standards. In addition, the current economic and industry environment in the telecommunications sector has resulted in pressure to reduce prices for our products, and we expect pricing pressure to continue for the foreseeable future, which may continue to adversely affect our operating results. Reduced spending by our customers has caused and may continue to cause increased price competition, resulting in a decline in the prices we charge for our products. If our customers and potential customers continue to constrain their spending, or if the prices we charge continue to decline, our revenues and margins may be adversely affected.

We will lose market share and may not be successful if our customers do not qualify our products to be designed into their products and systems or if our customers significantly delay purchasing our products.

In the telecommunications industry, service providers and optical systems manufacturers often undertake extensive qualification processes prior to placing orders for large quantities of products such as ours, because these products must function as part of a larger system or network. Once they decide to use a particular supplier’s product or component, these potential customers design the product into their system, which is known as a “design-in” win. Suppliers whose products or components are not designed in are unlikely to make sales to that company until the adoption of a future redesigned system at the earliest, which could occur several years after the last design-in win. If we fail to achieve design-in wins in potential customers’ qualification processes, we may lose the opportunity for significant sales to such customers for a lengthy period of time.

The long sales cycles for sales of our products to customers may cause operating results to vary from quarter to quarter, which could continue to cause volatility in our stock price, and may prevent us from achieving profitability.

The period of time between our initial contact with certain of our customers and the receipt of an actual purchase order from such customers often spans a time period of six to nine months, and sometimes longer. During this time, customers may perform, or require us to perform, extensive and lengthy evaluation and testing of our products and our manufacturing processes before purchasing our products. While our customers are evaluating our products before they place an order with us, we may incur substantial sales and marketing and research and development expenses, expend significant management efforts, increase manufacturing capacity and order long-lead-time supplies. For example, one of our largest customers recently required us to perform extensive and lengthy evaluation and testing of a proposed product. After such extensive work, we failed to be designed-in for that product. If we increase capacity and order supplies in anticipation of an order that does not materialize, our gross margins will decline and we will have to carry and write off excess inventory. Even if we receive an order, if we are required to add additional manufacturing capacity in order to service the customer’s requirements, such manufacturing capacity may be underutilized in a subsequent quarter, especially if an order is delayed or cancelled. Either situation could cause our results of operations to be below the expectations of investors and public market analysts, which could, in turn, cause the price of our common stock to decline.

If the communications industry does not continue to evolve and grow steadily, our business may not succeed.

Future demand for our products is uncertain and will depend to a great degree on the speed of the widespread adoption of optical networks. If the transition occurs too slowly or ceases altogether, the market for our products and the growth of our business will be significantly limited.

Our future success depends on the continued growth and success of the telecommunications industry, including the continued growth of the Internet as a widely used medium for commerce and communication and the continuing demand for increased bandwidth over communications networks. If the Internet does not continue to expand as a widespread communication medium and commercial marketplace, the need for significantly increased bandwidth across networks and the market for optical transmission products may not develop. As a result, it would be unlikely that our products would achieve commercial success.

The rate at which telecommunications service providers and other optical network users have built new optical networks or installed new systems in their existing optical networks has fluctuated in the past and these fluctuations may continue in the future. Sales of our components depend on sales of fiber optic telecommunications systems by our systems-level

customers, which are shipped in quantity when telecommunications service providers add capacity. Systems manufacturers compete for sales in each capacity deployment. If systems manufacturers that use our products in their systems do not win a contract, their demand for our products will decline, reducing our future revenues. Similarly, a telecommunications service provider’s delay in selecting systems manufacturers for a deployment could delay our shipments and revenues.

Difficulties in integrating our acquisitions of the optical components businesses of Alcatel, Corning and Vitesse have and could adversely impact our business.

We completed the acquisitions of the optical components businesses of Alcatel and Corning in July 2003 and Vitesse in August 2003. These acquisitions are the largest acquisitions we have completed, and the complex process of integrating these businesses has required, and will continue to require, significant resources. Integrating the businesses acquired from Alcatel, Corning and Vitesse has been and will continue to be time consuming and expensive. Failure to achieve the anticipated benefits of these acquisitions or to integrate successfully the operations of the acquired businesses could harm our business, results of operations and cash flows. We may not realize the benefits we anticipate from these acquisitions because of the following significant challenges:

As of March 31, 2005 we employed 837 employees, primarily located in California, New York, France and Italy. Prior to the acquisitions of the optical components businesses of Alcatel, Corning and Vitesse, most of our employees had been based at or near our headquarters in Fremont, California. As a result, we face challenges inherent in efficiently managing a large number of employees over large geographic distances, including the need to implement and manage appropriate systems, policies, benefits and compliance programs. The inability to successfully manage the substantially larger and geographically diverse organization, or any significant delay in achieving successful management, could have a material adverse effect on us and, as a result, on the market price of our common stock.

We have incurred and expect to continue to incur significant costs and commit significant management time integrating the operations, technology, development programs, products, information systems, customers and personnel of the businesses acquired from Alcatel, Corning and Vitesse. These costs have been and will likely continue to be substantial and include costs for:

In addition to the significant costs associated with converting and integrating Alcatel’s and Corning’s information systems, there are other significant risks associated with this process. For example, while migrating Alcatel or Corning data to our information system, we could lose such data or such data may be inaccessible to us during the lengthy integration process. In addition, we are in the process of upgrading and updating our information systems, which will be costly and will further divert management’s attention.

We regularly review acquisition and investment prospects that would complement our existing product offerings, augment our market coverage, secure supplies of critical materials or enhance our technological capabilities. Acquisitions or investments have resulted in, and in the future could result in, a number of financial consequences, including without limitation:

For example, as a result of our acquisitions of Holographix and LambdaFlex, we recorded in the first quarter of fiscal year 2003 a transitional goodwill impairment charge for all of our goodwill of $37.5 million, in accordance with Statement of Financial Accounting Standard No. 142 “Goodwill and Other Intangible Assets.” Further, as a result of our disposal of certain property, equipment and intellectual property rights, we recorded in the second quarter of fiscal year 2003 a charge for reduction in long-lived assets of $1.5 million, in accordance with Statement of Financial Accounting Standard No. 144 “Accounting for the Impairment or Disposal of Long-Lived Assets.”

In addition, in March 2002, we entered into an Agreement and Plan of Reorganization with Oplink Communications, pursuant to which we intended to acquire all of the outstanding capital stock of Oplink. The merger was subject to the approval of our stockholders and the stockholders of Oplink. While our stockholders approved the issuance of Avanex common stock in connection with the merger, the stockholders of Oplink failed to approve the merger in August 2002. We expensed $4.1 million in related merger expenses during the first quarter of fiscal year 2003.

Furthermore, acquisitions may involve numerous operational risks, similar to the integration and operational risks and costs described above with regard to the businesses acquired from Alcatel, Corning and Vitesse.

We have a limited operating history, which makes it difficult to evaluate our prospects and our operations.

We are in the optical systems and components industry. We were first incorporated in October 1997. Because of our limited operating history, we have limited insight into trends that may emerge in our industry and affect our business. The revenue and income potential of the optical systems and components industry, and our business in particular, are unproven. As a result of our limited operating history, we have limited financial data that can be used to evaluate our business. Our prospects must be considered in light of the risks, expenses and challenges we might encounter because we are in a new and rapidly evolving industry.

We face various risks related to our manufacturing operations that may adversely affect our business.

We may experience delays, disruptions or quality control problems in our manufacturing operations or the manufacturing operations of our third party manufacturers, and, as a result, product shipments to our customers could be delayed beyond the shipment schedules requested by our customers, which would negatively affect our business. Furthermore, even if we are able to timely deliver products to our customers, we may be unable to recognize revenue because of our revenue recognition policies. In the past, we have experienced disruptions in the manufacture of some of our products due to changes in our manufacturing processes, which resulted in reduced manufacturing yields, delays in the shipment of our products and deferral of revenue recognition. Any disruptions in the future could adversely affect our revenues, gross margins and results of operations. Changes in our manufacturing processes or those of our third party manufacturers, or the inadvertent use of defective materials by our third party manufacturers or us, could significantly reduce our manufacturing yields and product reliability. Because the majority of our manufacturing costs is relatively fixed, manufacturing yields are critical to our results of operations. Lower than expected manufacturing yields could delay product shipments and further impair our gross margins.

We may need to develop new manufacturing processes and techniques that will involve higher levels of automation to improve our gross margins and achieve the targeted cost levels of our customers. If we fail to effectively manage this process or if we experience delays, disruptions or quality control problems in our manufacturing operations, our shipments of products to our customers could be delayed.

We face risks related to our concentration of research and development efforts on a limited number of key industry standards and technologies, and our future success depends on our ability to develop and successfully introduce new and enhanced products that meet the needs of our customers in a timely manner.

In the past, we have concentrated our research and development efforts on a limited number of technologies that we believed had the best growth prospects. If we are unable to develop commercially viable products using these technologies, or these technologies do not become generally accepted, our business will likely suffer.

We have organized our product portfolio into two product groups: Active Optical Solutions and Passive Optical Solutions. These product groups consist of six solution categories: Transmission, Amplification, and Network Managed Subsystems, which are Active Optical Solutions, and Multiplexing and Signal Processing, Dispersion Compensation, and Switching and Routing, which are Passive Optical Solutions. Within each of these solution categories, we have numerous products to address the needs of our customers. The markets for our products are characterized by rapid technological change, frequent new product introduction, changes in customer requirements, and evolving industry standards. Our future performance will depend upon the successful development, introduction and market acceptance of new and enhanced products that address these changes. We may not be able to develop the underlying core technologies necessary to create new or enhanced products, or to license or otherwise acquire these technologies from third parties. Product development delays may result from numerous factors, including:

More recently, our industry has increased its focus on products that transmit voice, video and data traffic over shorter distances and are offered at lower cost than the products that we offer to our telecommunications customers for transmission of information over longer distances. If we are unable to develop products that meet the requirements of potential customers of these products, our business will suffer.

The development of new, technologically advanced products is a complex and uncertain process requiring high levels of innovation and highly skilled engineering and development personnel, as well as the accurate anticipation of technological and market trends. We cannot assure that we will be able to identify, develop, manufacture, market or support new or enhanced products successfully, or on a timely basis. In addition, the introduction of new and enhanced products may cause our customers to defer or cancel orders for existing products. To the extent customers defer or cancel orders for existing products due to the expectation of a new product release or if there is any delay in development or introduction of our new products or enhancements of our products, our operating results would suffer. Further, we cannot assure that our new products will gain market acceptance or that we will be able to respond effectively to competitive products, technological changes or emerging industry standards. Any failure to respond to technological change would significantly harm our business.

If we are unable to forecast component and material requirements accurately or if we are unable to commit to deliver sufficient quantities of our products to satisfy customers’ needs, our results of operations will be adversely affected.

Our customers typically require us to commit to delivering certain quantities of our products to them (in guaranteed safety stock, guaranteed capacity or otherwise) without committing themselves to purchase such products, or any quantity of such products. Therefore, wide variations between estimates of our customers’ needs and their actual purchases may result in:

We use a rolling six-month to twelve-month demand forecast based on anticipated and historical product orders to determine our component and material requirements. It is very important that we accurately predict both the demand for our products and the lead times required to obtain the necessary components and materials. It is very difficult to develop accurate forecasts of product demand, especially given the current uncertain conditions in the telecommunications industry. Order cancellations and lower order volumes by our customers have in the past created excess inventories. For example, the inventory write-offs taken in the years ended June 30, 2003, and June 30, 2002, were primarily the result of our inability to anticipate the sudden decrease in demand for our products. We have recorded $53.1 million of excess and obsolete inventory write-offs from our inception through March 31, 2005. If we fail to accurately predict both the demand for our products and the lead times required to obtain the necessary components and materials in the future, we could incur additional excess and obsolete inventory write-offs. If we underestimate our component and material requirements, we may have inadequate inventory, which could interrupt our manufacturing and delay delivery of our products to our customers. Any of these occurrences would negatively affect our results of operations.

Network carriers and telecommunication system integrators historically have required that suppliers commit to provide specified quantities of products over a given period of time. If we are unable to commit to deliver sufficient quantities of our products to satisfy a customer’s anticipated needs, we may lose the opportunity to make significant sales to that customer over a lengthy period of time. In addition, we may be unable to pursue large orders if we do not have sufficient manufacturing capacity to enable us to provide customers with specified quantities of products. If we cannot deliver sufficient quantities of our products, we may lose business, which could adversely impact our business, financial condition, and results of operations.

If our customers do not qualify our manufacturing processes they may not purchase our products, and our operating results could suffer.

Certain of our customers will not purchase our products prior to qualification of our manufacturing processes and approval of our quality assurance system. The qualification process determines whether the manufacturing line meets the quality, performance and reliability standards of our customers. These customers may also require that we, and any manufacturer that we may use, be registered under international quality standards, such as ISO 9001. In August 2000, we successfully passed the ISO 9001 registration audit and received formal registration of our quality assurance system at our Fremont facility, and we have passed subsequent reviews as well. Delays in obtaining customer qualification of our manufacturing processes or approval of our quality assurance system may cause a product to be removed from a long-term supply program and result in significant lost revenue opportunity over the term of that program.

All of the sites acquired as a result of the acquisitions of the optical components businesses of Alcatel and Corning are currently certified to ISO 9001.

Our dependence on independent manufacturers may result in product delivery delays and may harm our operations.

We rely on outsourced manufacturers to manufacture a portion of our components, subassemblies and finished products. We intend to develop further our relationships with these manufacturers so that they will eventually manufacture many of our high volume key components and subassemblies, and possibly a substantial portion of our finished products, in the future. The qualification of these independent manufacturers under quality assurance standards is an expensive and time-consuming process. Our independent manufacturers have a limited history of manufacturing optical subcomponents, and have no history of manufacturing our products on a turnkey basis. Any interruption in the operations of these manufacturers, or any deficiency in the quality or quantity of the subcomponents or products built for us by these manufacturers, could

impede our ability to meet our scheduled product deliveries to our customers. As a result, we may lose existing or potential customers. We have limited experience in working with outsourced manufacturers, and do not have contracts in place with many of these manufacturers. As a result, we may not be able to effectively manage our relationships with these manufacturers. If we cannot effectively manage our manufacturing relationships, or if these manufacturers fail to deliver components in a timely manner, we could experience significant delays in product deliveries, which may have an adverse effect on our business and results of operations. Increased reliance on outsourced manufacturing, and the ultimate disposition of our manufacturing capacity in the future, may result in impairment charges relating to our long-lived assets in future periods, which would have an adverse impact on our business, financial condition and results of operations. In addition, for a period of time as we transfer production of certain products to these third party manufacturers and as our customers qualify such third party manufacturers, we incur fixed and variable costs at both locations.

Our products may have defects that are not detected until full deployment of a customer’s network, which could result in a loss of customers and revenue and damage to our reputation.

Our products are designed to be deployed in large and complex optical networks and must be compatible with existing and future components of such networks. Our products can only be fully tested for reliability when deployed in networks for long periods of time. Our products may not operate as expected, and our customers may discover errors, defects, or incompatibilities in our products only after they have been fully deployed and are operating under peak stress conditions. If we are unable to fix errors or other problems, we could experience:

We may be required to indemnify our customers against certain liabilities arising from defects in our products, which liabilities may also include the following costs and expenses:

While we carry insurance policies covering this type of liability, these policies may not provide sufficient protection should a claim be asserted. To date, product defects have not had a material negative effect on our business, financial condition or results of operations, however we cannot be certain that they will not have a material negative effect on us in the future.

We depend on key personnel to manage our business effectively, and if we are unable to hire and retain qualified personnel, our ability to sell our products could be harmed.

Our future success depends, in part, on certain key employees and on our ability to attract and retain highly skilled personnel. We have recently hired a new President and Chief Executive Officer, who also recently was named as Chairman of the Board, and a new Chief Financial Officer. In addition, we have recently made other significant changes in our executive and management teams, and there can be no assurance that these changes will be successful. The loss of the services of any of our key personnel, the inability to attract or retain qualified personnel, or delays in hiring required personnel, particularly engineering, sales or marketing personnel, may seriously harm our business, financial condition and results of operations. None of our officers or key employees has an employment agreement for a specific term, and these employees may terminate their employment at any time. For example, one of our executive officers left Avanex in the first quarter of fiscal year 2005 and one of our executive officers left Avanex in the third quarter of fiscal year 2005. We do not

have key person life insurance policies covering any of our employees. Our ability to continue to attract and retain highly skilled personnel will be a critical factor in determining whether we will be successful in the future. Competition for highly skilled personnel is frequently intense, especially in the San Francisco Bay Area. We may not be successful in attracting, assimilating or retaining qualified personnel to fulfill our current or future needs.

We face various risks that could prevent us from successfully manufacturing, marketing and distributing our products internationally.

As a result of the acquisitions of the optical components businesses of Alcatel and Corning and the opening of our Operations Center in Thailand, we expanded our international operations, including expansion of overseas product manufacturing, and we may continue to expand internationally in the future. Further, we have increased international sales and intend to further increase our international sales and the number of our international customers. This expansion has required and will continue to require significant management attention and financial resources to successfully develop direct and indirect international sales and support channels. For instance, we have incurred, and may continue to incur, startup costs to open our Operations Center in Thailand, and may incur costs in transferring operations to Thailand. We may not be able to maintain international market demand for our products. We currently have limited experience in manufacturing, marketing and distributing our products internationally, particularly from our new Operations Center in Thailand. In addition, international operations are subject to inherent risks, including, without limitation, the following:

Historically our international revenues and expenses have been denominated predominantly in U.S. dollars; however, as a result of the acquisitions of the optical components businesses of Alcatel and Corning, a portion of our international revenues and expenses are now denominated in foreign currencies. Therefore, fluctuations in the value of foreign currencies could have a negative impact on the profitability of our global operations, which would seriously harm our business, financial condition and results of operations.

Current and future litigation against us could be costly and time consuming to defend.

We are regularly subject to legal proceedings and claims that arise in the ordinary course of business. Litigation may result in substantial costs and may divert management’s attention and resources, which may seriously harm our business, financial condition, results of operations and cash flows.

We may be unable to protect our proprietary technology, which could significantly impair our ability to compete.

We rely on a combination of patent, copyright, trademark and trade secret laws, confidentiality agreements and other contractual restrictions on disclosure to protect our intellectual property rights. We also rely on confidentiality agreements

with our employees, consultants and corporate partners, and controlled access to and distribution of our technology, software, documentation and other confidential information. We have numerous patents issued or applied for in the United States and abroad, of which some may be jointly filed or owned with other parties. Further, we license certain intellectual property from third parties, including Alcatel and Corning, that is critical to our business, and we also license intellectual property to other parties. We cannot assure you that any patent applications or issued patents will protect our proprietary technology, or that any patent applications or patents issued will not be challenged by third parties. Further, we cannot assure you that parties from whom we license intellectual property will not violate their agreements with us; that their patent applications, patents and other intellectual property will protect our technology, products and business; or that their patent applications, patents and other intellectual property will not be challenged by third parties. Our intellectual property also consists of trade secrets, which require more monitoring and control mechanisms to protect. Despite our efforts to protect our proprietary rights, unauthorized parties may attempt to copy or otherwise obtain and use our products or technology. Monitoring unauthorized use of our products is difficult, and we cannot be certain that the steps we take will prevent misappropriation or unauthorized use of our technology. Further, other parties may independently develop similar or competing technology or design around any patents that may be issued or licensed to us.

We use various methods to attempt to protect our intellectual property rights. However, we cannot be certain that the steps we have taken will prevent the misappropriation of our intellectual property. In particular, the laws in foreign countries may not protect our proprietary rights as fully as the laws in the United States.

We face risks with regard to our third-party intellectual property licenses.

From time to time we may be required to license technology from third parties to develop new products or product enhancements. We cannot assure you that third-party licenses will be available to us on commercially reasonable terms, if at all. The inability to obtain a necessary third-party license required to develop new products and product enhancements could require us to substitute technology of lower quality or performance standards, or of greater cost, either of which could prevent us from operating our business. For example, Alcatel currently holds patent cross licenses with various third parties that may be necessary for us to operate our business. We cannot guarantee that we will be able to obtain these patent licenses from these third parties, or that we will be able to obtain these licenses on favorable terms. If we are not able to obtain licenses from these third parties, then we may be subject to litigation to defend against infringement claims from these third parties. Further, Alcatel has cross licenses with various third parties, which when combined with their own intellectual property, may permit these thirds parties to compete with us.

We may become subject to litigation or claims from or against third parties regarding intellectual property rights, which could divert resources, cause us to incur significant costs, and restrict our ability to utilize certain technology.

We may become a party to litigation in the future to protect our intellectual property or we may be subject to litigation to defend against infringement claims of others. These claims and any resulting lawsuit, if successful, could subject us to significant liability for damages and invalidation of our proprietary rights. These lawsuits, regardless of their success, would likely be time-consuming and expensive to resolve and would divert management time and attention. Any potential intellectual property litigation also could force us to do one or more of the following:

If we are forced to take any of these actions, our business may be seriously harmed. Although we carry general liability insurance, our insurance may not cover potential claims of this type or may not be adequate to indemnify us for all liability that may be imposed. We may in the future initiate claims or litigation against third parties for infringement of our proprietary rights in order to determine the scope and validity of our proprietary rights or the proprietary rights of competitors. These claims could result in costly litigation and the diversion of our technical and management personnel.

Our business and future operating results may be adversely affected by events that are outside of our control.

Our business and operating results are vulnerable to interruption by events outside of our control, such as earthquakes, fire, power loss, telecommunications failures and uncertainties arising out of terrorist attacks throughout the world, including

the continuation or potential worsening of the current global economic environment, the economic consequences of additional military action and associated political instability, and the effect of heightened security concerns on domestic and international travel and commerce. We cannot be certain that the insurance we maintain against fires, floods and general business interruptions will be adequate to cover our losses for such events in any particular case.

In addition, we handle hazardous materials as part of our manufacturing activities and are subject to a variety of governmental laws and regulations related to the use, storage, recycling, labeling, reporting, treatment, transportation, handling, discharge and disposal of such hazardous materials. Although we believe that our operations conform to presently applicable environmental laws and regulations, we may incur costs in order to comply with current or future environmental laws and regulations, including costs associated with permitting, investigation and remediation of hazardous materials and installation of capital equipment relating to pollution abatement, production modification and/or hazardous materials management. In addition, we currently sell products that incorporate firmware and electronic components. The additional level of complexity created by combining firmware and electronic components with our optical components requires that we comply with additional regulations, both domestically and abroad, related to power consumption, electrical emissions and homologation. Any failure to successfully obtain the necessary permits or comply with the necessary laws and regulations could have a material adverse effect on our operations.

Certain provisions of our certificate of incorporation and bylaws and Delaware law could delay or prevent a change of control of us.

Certain provisions of our certificate of incorporation and bylaws and Delaware law may discourage, delay or prevent a merger or acquisition that a stockholder may consider favorable. These provisions allow us to issue preferred stock with rights senior to those of our common stock and impose various procedural and other requirements that could make it more difficult for our stockholders to effect certain corporate actions.

In addition, Alcatel and Corning own shares of Avanex common stock representing 19.55% and 11.87%, respectively, of the outstanding shares of Avanex common stock as of May 2, 2005. Pursuant to the stockholders’ agreement entered into by Avanex, Alcatel and Corning, Alcatel and Corning are generally required to vote on all matters as recommended by the board of directors of Avanex, except, in the case of Alcatel, for proposals relating to certain acquisition transactions between Avanex and certain competitors of Alcatel. The concentration of ownership of our shares of common stock, combined with the voting requirements contained in the stockholders’ agreement, could have the effect of delaying or preventing a change of control or otherwise discourage a potential acquirer from attempting to obtain control of us, unless the transaction is approved by our board of directors.

Our exposure to market risk for changes in interest rates relates primarily to our investment portfolio. The objectives of our investment activities are preservation and safety of principal; maintenance of adequate liquidity to meet cash flow requirements; attainment of a competitive market rate of return on investments; minimization of risk on all investments; and avoidance of inappropriate concentrations of investments.

We place our investments with high quality credit issuers in short-term and long-term securities with maturities ranging from overnight to 36 months. The average maturity of the portfolio will not exceed 18 months. The portfolio includes only marketable securities with active secondary or resale markets to ensure portfolio liquidity. We do not have any derivative financial instruments. Accordingly, we do not believe that our investments have significant exposure to interest rate risk.

We have one equipment loan with a fixed rate of interest of 5.2%, with aggregate remaining principal and interest payments of $548,000 as of March 31, 2005.

The following table summarizes average interest rate and fair market value of the short-term and long-term securities held by Avanex (dollars in thousands).

Our international business is subject to normal international business risks including, but not limited to, differing economic conditions, changes in political climate, differing tax structures, other regulations and restrictions, and foreign exchange rate volatility. Accordingly, our future results could be materially adversely affected by changes in these or other factors.

We have operations in the United States, Thailand, France and Italy. Accordingly, we have sales and expenses that are denominated in currencies other than the U.S. dollar. As a result, currency fluctuations between the U.S. dollar and the currencies in which we do business could cause foreign currency translation gains or losses that we would recognize in the period incurred. A 10% fluctuation in the dollar at March 31, 2005 would have led to an additional profit of approximately $410,000 (dollar strengthening), or an additional loss of approximately $410,000 (dollar weakening) on our net dollar position in outstanding trade payables and receivables. We cannot predict the effect of exchange rate fluctuations on our future operating results because of the variability of currency exposure and the potential volatility of currency exchange rates. Currently, we do not hedge our exposure to translation gains and losses related to foreign currency net asset exposures.

Our management evaluated, with the participation of our Chief Executive Officer and our Chief Financial Officer, the effectiveness of our disclosure controls and procedures as of the end of the period covered by this Quarterly Report on Form 10-Q. Based on this evaluation, our Chief Executive Officer and our Chief Financial Officer have concluded that our disclosure controls and procedures are effective to ensure that information we are required to disclose in reports that we file or submit under the Securities Exchange Act of 1934 is accumulated and communicated to our management, including our principal executive and principal financial officers, as appropriate to allow timely decisions regarding required disclosure, and that such information is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms.

We continue to enhance our internal control over financial reporting by adding resources in key functional areas with the goal of bringing our operations up to the level of documentation, segregation of duties, and systems security necessary, as well as transactional control procedures required under the new Auditing Standard No. 2 issued by the Public Company Accounting Oversight Board. We discuss and disclose these matters to the audit committee of our board of directors and to our auditors. There were no significant changes to our internal controls during our most recent quarter that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

On February 28, 2005, Avanex entered into a Seventh Amendment to Amended and Restated Revolving Credit and Security Agreement with Comerica Bank-California (the “Seventh Amendment”). The Seventh Amendment, among other things, reduces the maximum borrowings allowed pursuant to the underlying line of credit from $20.0 million to $10.0 million and extends the term of the underlying line of credit through January 1, 2006. The Seventh Amendment is filed herewith as Exhibit 10.1 and is incorporated herein by reference.

On April 12, 2005, Avanex entered into an Eighth Amendment to Amended and Restated Revolving Credit and Security Agreement with Comerica Bank-California (the “Eighth Amendment”). The Eighth Amendment, among other things, permits the collateralization of certain obligations of Avanex against certain deposit accounts and certificates of deposit of Avanex, and contains a waiver by the lender of a covenant in the underlying line of credit. The Eighth Amendment is filed herewith as Exhibit 10.2 and is incorporated herein by reference.

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.


AVANEX CORPORATION
(Registrant)

By:		/s/ RICHARD C. YONKER
		Richard C. Yonker
		Chief Financial Officer
		(Duly Authorized Officer and Principal Financial and Accounting Officer)

Date:		May 10, 2005


		Page No.
PART I. FINANCIAL INFORMATION

Item 1.	Condensed Consolidated Financial Statements (Unaudited):

	Condensed Consolidated Balance Sheets as of March 31, 2005 and June 30, 2004	3

	Condensed Consolidated Statements of Operations for the Three and Nine Months Ended March 31, 2005 and 2004	4

	Condensed Consolidated Statements of Cash Flows for the Nine Months Ended March 31, 2005 and 2004	5

	Notes to Condensed Consolidated Financial Statements	6

Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	17

Item 3.	Quantitative and Qualitative Disclosures About Market Risk	41

Item 4.	Controls and Procedures	42

PART II. OTHER INFORMATION

Item 1.	Legal Proceedings	43

Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	43

Item 3.	Defaults Upon Senior Securities	43

Item 4.	Submission of Matters to a Vote of Security Holders	43

Item 5.	Other Information	43

Item 6.	Exhibits	43

Signatures		44


	March 31, 2005			June 30, 2004
ASSETS
Current assets:
Cash and cash equivalents	$	7,966		$	21,637
Short-term investments (including $10.4 and $10.4 million restricted at March 31, 2005 and June 30, 2004, respectively)		34,407			67,453
Accounts receivable, net		20,377			16,610
Inventories		39,810			39,003
Due from related parties		16,008			14,599
Other current assets		14,868			15,678

Total current assets		133,436			174,980
Long-term investments (including $6.9 million and $11.4 million restricted at March 31, 2005 and June 30, 2004, respectively)		29,402			55,145
Property and equipment, net		11,717			13,977
Intangibles, net		10,723			14,400
Goodwill		9,408			9,408
Other assets		6,182			7,286

Total assets	$	200,868		$	275,196

LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Short-term borrowings	$	3,877		$	3,723
Accounts payable		27,220			26,508
Accrued compensation and related expenses		10,683			11,239
Warranty		5,919			6,125
Due to related parties		1,834			2,609
Other accrued expenses and deferred revenue		12,866			13,531
Current portion of other long-term obligations		3,117			3,968
Current portion of restructuring costs		15,552			23,473

Total current liabilities		81,068			91,176
Long-term liabilities:
Restructuring costs		13,960			15,191
Other long-term obligations		11,819			11,365

Total liabilities		106,847			117,732

Commitments and contingencies (Note 13)
Stockholders’ equity:
Common stock		145			143
Additional paid-in capital		665,174			663,798
Deferred compensation		(404	)		(596	)
Cumulative translation adjustment		5,739			5,193
Accumulated deficit		(576,633	)		(511,074	)

Total stockholders’ equity		94,021			157,464

Total liabilities and stockholders’ equity	$	200,868		$	275,196


	Three Months Ended March 31						Nine Months Ended March 31
	2005			2004			2005			2004
Net revenue
Third parties	$	27,480		$	20,935		$	75,157		$	52,858
Related parties		12,837			9,169			42,826			22,205

Total net revenue		40,317			30,104			117,983			75,063
Cost of revenue
Third parties		39,172			26,344			114,063			72,318
Direct material purchases from related parties		2,214			9,937			8,369			23,846
Stock compensation expense		—			—			—			31

Gross loss		(1,069	)		(6,177	)		(4,449	)		(21,132	)
Operating expenses:
Research and development		8,625			10,687			24,788			31,234
Sales and marketing		4,148			5,136			13,010			14,469
General and administrative
Third parties		2,788			5,225			8,765			14,173
Related parties		1,598			2,605			4,276			5,086
Stock compensation expense (1)		53			135			293			706
Amortization of intangibles		1,242			1,267			3,723			3,302
Restructuring charges		14			9,103			8,043			8,571
Gain on disposal of property and equipment		(410	)		—			(1,886	)		—
Merger costs		—			—			300			—

Total operating expenses		18,058			34,158			61,312			77,541

Loss from operations		(19,127	)		(40,335	)		(65,761	)		(98,673	)
Interest and other income		498			1,060			1,669			3,380
Interest and other expense		(257	)		(491	)		(1,467	)		(1,100	)

Loss from continuing operations before discontinued operations		(18,886	)		(39,766	)		(65,559	)		(96,393	)
Loss from discontinued operations		—			(1,265	)		—			(6,054	)

Net loss	$	(18,886	)	$	(41,031	)	$	(65,559	)	$	(102,447	)

Loss per share from continuing operations before discontinued operations	$	(0.13	)	$	(0.28	)	$	(0.46	)	$	(0.76	)
Loss per share from discontinued operations		—			(0.01	)		—			(0.05	)

Basic and diluted net loss per common share	$	(0.13	)	$	(0.29	)	$	(0.46	)	$	(0.81	)

Weighted-average number of shares used in computing basic and diluted net loss per common share		144,468			139,372			144,064			126,322


(1) Allocation of stock compensation expense:
Research and development	$	38		$	77		$	157		$	280
Sales and marketing		15			58			46			319
General and administrative		—			—			90			107

	$	53		$	135		$	293		$	706


	Nine Months Ended March 31,
	2005			2004
OPERATING ACTIVITIES:
Net loss	$	(65,559	)	$	(102,447	)
Adjustments to reconcile net loss to net cash used in operating activities:
Gain on disposal of property and equipment		(1,886	)		918
Depreciation and amortization		7,058			12,136
Amortization of intangibles		3,723			3,302
Stock compensation expense		293			737
Provision for doubtful accounts and sales returns		649			1,495
Provision for excess and obsolete inventory		4,780			928
Provision for warranty costs, net of adjustments		415			407
Changes in operating assets and liabilities:
Accounts receivable		(3,736	)		9,581
Inventories		(4,488	)		(9,885	)
Other current assets		450			3,485
Other assets		1,417			4,619
Due to/from related parties		(2,184	)		(16,000	)
Accounts payable		1,158			3,977
Accrued compensation and related expenses		(262	)		1,393
Accrued restructuring		(13,073	)		(49,875	)
Warranty		(705	)		(2,667	)
Other accrued expenses and deferred revenues		693			(1,176	)

Net cash used in operating activities		(71,257	)		(139,072	)

INVESTING ACTIVITIES
Purchases of held-to-maturity securities		(41,805	)		(171,839	)
Maturities of held-to-maturity securities		100,957			161,269
Acquisitions, net of cash acquired		—			117,986
Purchase of other investments		—			(4,400	)
Purchases of property and equipment		(2,895	)		(1,494	)
Proceeds from sale of fixed assets		2,924			—

Net cash provided by investing activities		59,181			101,522

FINANCING ACTIVITIES
Payments on long-term debt and capital lease obligations		(3,784	)		(4,185	)
Proceeds from short-term borrowings		31,219			76,108
Payments on short-term borrowings		(31,065	)		(78,703	)
Borrowings under financing arrangements		—			865
Proceeds from issuance of common stock, net of repurchases		1,276			70,868

Net cash (used) provided by financing activities		(2,354	)		64,953

Effect of exchange rate changes on cash		759			7,657

Net (decrease) increase in cash and cash equivalents		(13,671	)		35,060
Cash and cash equivalents at beginning of period		21,637			10,639

Cash and cash equivalents at end of period	$	7,966		$	45,699

Supplemental Information:
Cash paid during the period for:
Interest expense		404			783
Non-cash investing and financing activities:
Property and equipment acquired under capital lease		2,271			—


	Alcatel Optronics		Corning Asset Purchase		Vitesse Asset Purchase
Value of securities issued	$	63,064	$	38,289	$	6,509
Transaction costs and expenses		6,533		3,820		297

Total purchase price	$	69,597	$	42,109	$	6,806


	Three Months Ended March 31,						Nine Months Ended March 31,
	2005			2004			2005			2004
Net revenues	$	40,317		$	30,104		$	117,983		$	84,788
Net loss	$	(18,886	)	$	(41,031	)	$	(65,559	)	$	(113,965	)

Weighted-average shares outstanding—basic and diluted		144,468			139,372			144,064			133,000
Basic and diluted loss per share	$	(0.13	)	$	(0.29	)	$	(0.46	)	$	(0.86	)


	March 31, 2005		June 30, 2004
Raw materials	$	18,719	$	23,260
Work-in-process		7,593		6,565
Finished goods		13,498		9,178

	$	39,810	$	39,003


	March 31, 2005			June 30, 2004
Purchased technology	$	16,227		$	16,165
Supply agreement		1,838			1,838
Other		970			882

		19,035			18,885
Less accumulated amortization		(8,312	)		(4,485	)

	$	10,723		$	14,400


Fiscal Year	Amount
2005 (remaining three months)	$	1,243
2006		4,971
2007		4,134
2008		375

Totals	$	10,723


	March 31, 2005			June 30, 2004
Acquisition-related accruals	$	10,048		$	13,135
Other		19,464			25,529

Total restructuring accruals		29,512			38,664
Less current portion		(15,552	)		(23,473	)

	$	13,960		$	15,191


	Acquisition-Related Accrual at June 30, 2004		Cash Payments			Acquisition-Related Accrual at March 31, 2005
Workforce Reduction	$	13,135	$	(3,087	)	$	10,048


	Accrual at June 30, 2004		Additional Accrual		Cash Payments			Recovery			Accrual at March 31, 2005
Workforce Reduction-FY2004	$	6,271	$	4,289	$	(8,516	)	$	(461	)	$	1,583
Workforce Reduction-FY2005	$	—	$	4,215	$	(1,490	)					2,725
Abandonment of excess leased facilities		18,812		—		(3,656	)		—			15,156
Capital leases		446		—		(446	)		—			—

Total	$	25,529	$	8,504	$	(14,108	)	$	(461	)	$	19,464


	March 31, 2005		June 30, 2004
United States	$	4,126	$	4,459
Europe		7,591		9,518

	$	11,717	$	13,977


	Contractual Obligations Due by Period
	Total		Less than 1 year		1-3 years		4-5 years		After 5 years
Long-term debt	$	548	$	313	$	235	$	—	$	—
Capital lease obligations		9,118		2,952		5,472		693		—
Operating leases		29,192		6,441		12,901		8,300		1,550
Pension obligations		4,642		4,642		—		—		—
Workforce Reduction		14,356		14,356		—		—		—
Unconditional purchase obligations		32,653		32,653		—		—		—

Total contractual cash obligations	$	90,509	$	61,357	$	18,608	$	8,993	$	1,550


	Other Commercial Commitments Commitment Expiration Per Period
	Total Amounts Committed		Less than 1 year		1-3 years		4-5 years		After 5 Years
Line of credit	$	3,877	$	3,877	$	—	$	—	$	—
Standby letters of credit		6,787		6,787		—		—		—

Total commercial commitments	$	10,664	$	10,664	$	—	$	—	$	—


	Period Ending March 31,					Total Amortized Cost		Fair Market Value
	2005			2006		Total Amortized Cost		Fair Market Value
Held-to-maturity securities	$	34,407		29,402		$	63,809	$	62,969
Average interest rate		2.0	%	2.0	%


	Period Ending June 30,						Total Amortized Cost		Fair Market Value
	2004			2005			Total Amortized Cost		Fair Market Value
Held-to-maturity securities	$	67,453		$	55,145		$	122,598	$	121,110
Average interest rate		2.1	%		2.2.	%


10.1		Seventh Amendment to Amended and Restated Revolving Credit and Security Agreement dated February 28, 2005 between the Registrant and Comerica Bank-California

10.2		Eighth Amendment to Amended and Restated Revolving Credit and Security Agreement dated April 12, 2005 between the Registrant and Comerica Bank-California

31.1		Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

31.2		Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

32.1		Certification of Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.